According to the Financial Post, Canada's banking regulator, the Office of the Federal Financial Administrator (OSFI), is taking new steps to ensure that lenders do not accept too many highly indebted borrowers, especially if borrowers are more likely to borrow large amounts after the central bank enters the interest rate cut channel, which will increase the risk for banks.
However, this new move by OSFI is mainly to strengthen the supervision of banks, and will not be reflected in individual mortgage borrowers. OSFI will monitor the loan-to-income ratios on a quarterly basis to ensure that uninsured mortgages in banks that borrow more than 4.5 times the borrower's annual income remain at a percentage (preliminary or 25%). The measure will take effect in the first quarter of next year.
The new rules mainly monitor banks
In recent years, mortgage payments have surged as housing prices have risen, making Canada one of the most indebted borrowers in the world. This new measure for banks' mortgage structures aims to "prevent the accumulation of 'highly leveraged loans' during periods of low interest rates".
Loans that exceed 4.5 times the borrower's income are a relatively high-risk group, the regulator said. If they lose their jobs or suddenly need to pay a higher interest rate, then these people are more likely to default on their loans.
This can be learned from the history of long periods of low interest rates prior to the spring of 2022. In a low interest rate environment, large mortgages can be managed, but as interest rates rise, the surge in loan amounts creates greater challenges for borrowers and their financial institutions.
OSFI will monitor the banks individually and test them according to the business model of each institution. OSFI said this approach would allow banks to continue to use existing underwriting methods in the current interest rate environment and compete as before.
"This measure does not apply to any individual, but to the composition of mortgages issued by lenders during the quarter, which are self-managed and subject to OSFI supervision," the report said.
In other words, OSFI will regulate the mortgage structure of banks from a macro perspective. If a bank issues a certain percentage of "high-risk loans with a loan-to-income ratio of more than 4.5 times" in a quarter, the bank may reduce such high-risk mortgages in the next quarter.
For individual mortgage applicants, if you happen to be such a high-risk borrower, whether you can approve the loan depends on whether the bank has used up its share of the high-risk portion.
In addition, the new rules only apply to new mortgages and do not apply to existing or renewal loans.
Similarly, this provision does not apply to borrowers who have to pay mortgage insurance because the down payment is less than 20% of the purchase price of the property.
There's still a buffer in Vancouver Toronto
In addition, at the individual level of the borrower, if the loan amount exceeds 4.5 times the borrower's income, the bank can also allow the individual borrower to exceed the cap, "as long as the average [loan-to-income ratio] of the entire [institution's] mortgage portfolio is 4.5 times or less."
Banks will be allowed to lend to certain customers in excess of the new loan-to-income ratio, creating some buffer for borrowers in expensive cities like Toronto and Vancouver, according to Financial Post. But lenders will also be subject to the overall cap on mortgages, which will constrain their discretion.
Banks say they are ready
Canada's big banks have also set aside more funds to deal with possible non-performing loans since the central bank started raising interest rates and regulators asked banks to show strong capital positions.
"Canadian banks have long partnered with their customers to keep their mortgages in good shape," the Canadian Bankers Association, a top lobbying group, said. "
According to Financial Post's analysis, some lenders may charge additional fees to some borrowers with high loan-to-income ratios to help compensate for the risk of their loans far exceeding the upper limit of their income ratio. Doing so would also help banks limit the number of highly indebted borrowers in their mortgage structure.
In general, banks may want to open a "side door" for higher-quality and more profitable customers. This may cause some highly indebted borrowers to turn to loans from non-federally regulated financial institutions or non-prime lenders.
The impact of the new test on the mortgage market
According to an analysis by Financial Post, the impact was not significant at first. But once interest rates start to fall, the borrower's stress test will apply a lower qualifying rate, and the borrower will qualify for a larger mortgage – meaning the loan-to-income ratio will rise.
Still, there will be many borrowers who won't earn more than 4.5 times their loan income, especially if they've already paid off most of their mortgage and renewed it. This will reduce the overall ratio of the bank's mortgage composition.
Looking back at historical data, the proportion of highly leveraged borrowers has declined significantly since the peak of the housing boom in early 2022. According to the central bank, in the last quarter of 2023, the proportion of new loans with a mortgage-to-income ratio above 450% was 12%. , well below the 26% recorded in the first quarter of 2022.
Overall, there is still an opportunity for banks to lend more highly leveraged loans.