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Expect waterfall effect from new mortgage rules

New mortgage rules kicked in yesterday… the two major rule changes are:

  • Maximum Amortization – 30 yrs (was 35yrs)
  • Maximum Refinancing – 85% of home value (was 90%) (remember, this is not applicable for new mortgages, only for refinances)

I think the rules will have a cascading waterfall effect on all but the upper end of the housing market…

Let’s say John is a marginal first time home buyer and he qualifies for a maximum monthly mortgage payment of $1000 with a 35 year amortization on a $300k mortgage. With the new rule of 30 year amortization, the maximum amount John qualifies for drops by about 7% to $930 and so the maximum mortgage John can qualify for is about $279k (roughly speaking).

If John was buying a resale home, there are two things that can happen:

  1. John would now have to look at homes listed at approximately 7% less than what John was willing to purchase earlier OR
  2. The seller – Ram – of the house has to reduce the house price by 7%.

If John chooses to look at smaller houses, the seller has to attract new buyers but because John is a marginal buyer i.e. a buyer on the fringe, Ram cannot find new buyers willing to pay the original price of $300k. What does Ram do?

Ram drops the price… how does that affect Ram?

Presumably Ram wants to buy a bigger house from seller X but because Ram received less money than expected for his current house, Ram will have less money for down payment and because of the rule change will have to settle for a smaller or a less pricey house. How much less? A lot more than 7%… around 11% because of the double whammy! See table for calculation.

Buyer Seller Before March 18 After March 18 Reduction in Affordability
John Ram $ 300,000 $ 279,000 7.00%
Ram X $ 500,000 $ 445,470* 10.91%

*445470 = (500000 – 21000) * 0.93 (because Ram received 21000 less, Ram has no choice but to buy a smaller house)

Now seller X wants to buy an even bigger house from seller Filthy Rich… you see where it’s going?

The cascading effect will continue all the way up to the housing market chain… except for maybe the high end/million dollar plus market… worry not, the recent stock market jitters might scare them away!

On the plus side though, banks reduced fixed rates by 10-20 bp recently, perhaps and coincidently in anticipation of slowing momentum in the housing market? (Note that bond rates have recently inched up, so not sure why rates have come down)

Going forward, I will be posting less about Canadian housing… I recently bought a house and I’m still bearish on Canadian housing.

  1. jesse
    March 19, 2011 at 4:57 PM

    Banks reduced their mortgage rates because they compete directly with government debt for capital.

    • March 19, 2011 at 5:30 PM

      that seems counterintuitive… if banks are competing for capital which is presumably the source of funds for new mortgages, how would reducing rates entice new capital to flow to banks? And wouldn’t reducing rates decrease their spread?

      Banks are not obliged to cut their spreads after all…even if their cost of funding changes, right?

      excuse my naivety… thanks 🙂

  2. Gary
    March 21, 2011 at 8:52 AM

    Congrats on the new home!

    I’m also on the bearish side when it comes to Canadian housing for the near-medium term. However, life is more than just a serious of logical black and white decisions. I’ve decided to hold a wait-and-see position which has no perceived downside for the near term. The only issue I’m having right now is convincing the significant other to invest during the waiting period. Fear of massive losses like 2008 plunge are keeping us out of the equity/commodity markets. And yet I have strong beliefs that we won’t see a pull back till QE ends. However, nothing I’ve seen would tell me that QE is ever ending.

    What are your thoughts on that?

    • April 14, 2011 at 8:08 AM

      thanks and apologies for the late reply – was busy with selling my condo & catching up on CFA.

      i honestly have no idea where the equity/commodity markets are headed but I think Sell in May is a good idea this year… mostly due to end of QE (tentative as it may be) and also due to the lack of 10%+ correction in equities… last year around this time money managers were expecting a similar correction in summer, but it didn’t happen and instead QE triggered a massive rally, this year unless there are positive economic/earnings surprises, I don’t see a catalyst for equity rally.

      i’m trading opportunistically in the short-term but sitting on cash for the most part (+ won’t have much left after the house purchase ;).

      As for QE – I think it will end this year but rates will be low for a long time… many US bloggers have interesting thoughts on the Fed’s dilemma with raising rates and excess reserves.

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