Why longer-term mortgages could be beneficial

by Gerv Tacadena on 22 Jan 2020

In Canada, longer-term mortgages are a rare sight. However, a recent analysis shows that making Canada's lending industry more open to longer-term mortgages could actually enhance financial stability and provide consumers with more options.

In a study for the C.D. Howe Institute, market expert Michael Feldman said the current lending landscape in Canada is geared towards a five-year mortgage market. In fact, figures from the Bank of Canada show that only 2% of all mortgages issued in 2018 were fixed-rate loans with terms longer than five years.

"The custom in Canada for residential mortgages to have legal maturity of five years or less is too well-entrenched to be overcome organically without incentives or changes to laws or government policies and programs to encourage this development," he said.

Feldman said the popularity of the five-year term came from the passing of the Interest Act in 1880. Section 10 of the law gives borrowers the option of redeeming the mortgage after five years with a penalty of no more than three months' interest. The reinvestment risks associated with this make lenders hesitant to offer terms of more than five years.

"If the lender could not re-invest the prepaid amount to earn a rate of return equal to the interest rate of the prepaid mortgage, it would bear all of the forgone earnings opportunity. This could be a particularly acute problem if the lender had locked in 10-year funding at a higher interest rate," Feldman said.

In a speech early last year, Bank of Canada Governor Stephen Poloz urged lenders to offer longer-term mortgages, saying doing so could boost flexibility for borrowers and investors and ease risks in the financial system.

"To be clear, the system is not broken — it has served Canadians and financial institutions well. But we should not stop looking for improvements and I invite all of you to join this effort," he said.

Poloz also said that longer-term mortgages could provide borrowers an opportunity to accumulate more equity in their home, boosting their options when they renew their deals.

Feldman said that regulatory changes are needed to significantly change the dominant custom in Canada's lending market. One is to revise the stress test.

"Since the main purpose of the stress test is to predict the ability of borrowers to continue to service their mortgages if they must renew at maturity at a higher interest rate, it would be logical to loosen the stress test for borrowers willing to fix their rates for terms longer than five years," he said.

Amending section 10 of the Interest Act is also a possible solution. The government can lengthen the redemption right from five years to 10 years.

"It would greatly reduce or eliminate the premium that a lender would have to charge for its reinvestment risk on mortgages up to 10 years. A reduction in this pricing premium would be expected to lead to more 10-year mortgages," Feldman said.

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