Time Mortgage Bomb

According to CMHC, 30% of all Canadian mortgages are now variable rate mortgages, up from 3% in 1998. And fixed 5 year terms account for almost 70% of the mortgage market.

So why don't many Canadians take out a 25 year mortgage? They exist. Royal Bank even lists them on their residential mortgage rate page.

It's all about 'affordability', the real estate industry's favorite catchword.

A 7.85% rate on a $555,000 amortized over 35 years results in a monthly payment of $4,420.

You can currently get a 1 year variable rate for 2.35%, which translates into a monthly payment of $2,495.

That's almost $2,000 a month less in payments.

So who in their right mind would opt for a 25 year mortgage? Even a five year rate from Royal (4.19%) will set you back $3,070 a month.

And for all those suckers buyers rushing into the market right now because homes are 'affordable' (i.e. low interest rates), saving $500 a month makes all the difference in the world.

And besides, rates have been relatively low for the past 8 years. They will stay like this for a long time.

And therein lies the looming disaster.

$500 makes all the difference in the world. As rates start to go up, many variable rate mortgage holders won't lock into 10 or 25 year rates. It's too much of a jump.

They won't even lock into a five year rate.

They have rationalized 'affordability' to make the purchase. When rates jump up 2%, the one year variable rate will cost them $500 more. To lock into a 5 year rate will cost them another $500 over that (at least).

The same argument that keeps them in a one year rate, will keep them in that rate then.

Even if some do lock in to a longer term rate, it will be a five year rate - at best.

But the fuse on the Lower Mainland mortgage time bomb will have been lit. And when it explodes this is what it will look like.

As the San Francisco Chronicle reports, the Bay area is sitting on a $30 Billion dollar time bomb of homes purchased with loans known as option ARMs, short for adjustable rate mortgages (Alt-A).

From 2004 to 2008, "one in five people who took out a mortgage loan (for both purchases and refinancing) in the San Francisco metropolitan region got an option ARM," said Bob Visini, senior director of marketing in San Francisco at First American CoreLogic, a mortgage research firm.

With these mortgages, the interest rate will reset after 5 years to a dramatically higher rate. Buyers took them because Alt-A and Option ARM allowed them to enjoy an 'affordable' low interest rate for the first five years. At the end of five years (during the boom years), buyers were advised they could re-negotiate a new mortgage (with a new low five year rate) especially since the value of their home will have risen.

Problem is... housing prices in San Francisco have evaporated... and so has the chance to obtain a new mortgage. It means thousands of buyers in the Bay area are going to be forced to watch their mortgages reset at dramatically higher interest rates as their five year terms expire.

There are over 54,000 option ARMs issued in greater San Francisco with a value of about $30.9 billion.

"In markets where home prices were going up rapidly, more and more borrowers needed a product like this to afford something," said Alla Sirotic, senior director at Fitch Ratings. The loans became a tool for regular people to "stretch" to buy homes that were beyond their means.

Can you see the parallel to what may happend in Canada when mortgage rates start rising?

The sad thing is, if you can, you are in the minority.

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Email: village_whisperer@live.ca
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