Rational Advisor

A great article in the Financial Post about the problems with a 40 year amortization

40 YEARS OF DEBT

Garry Marr
Financial Post

Saturday, September 08, 2007

CREDIT: Peter J. Thompson, National Post
Mortgages with 40-year amortizations are shaking up the market. Some say they are the only way to afford today’s home prices. Ron Cirotto, of www.amortization.com, calls that “bullshit.” “There are a lot of people buying a house who shouldn’t be buying the house they’re buying.”

Do not pay until 2047. It has a nice ring to it for Canadians seduced into home ownership but unable to afford the price tag that comes with buying property. No money for a down payment? Little cash to make monthly payments? No worries. The Canadian real estate industry has come up with the perfect product — the 40-year amortization.

Instead of planning to pay off their mortgage in 25 years, Canadians are now turning to products that give them at least an extra decade to pay their debt — subject to massive interest payments over the course of a loan.

Benjamin Tal, a senior economist with CIBC World Markets, says the change in the way Canadians pay off their mortgage is the most significant innovation to hit the industry in almost three decades.

“This has happened in just the past 16 months,” says Mr. Tal, who doesn’t believe the changes are necessarily bad for consumers or the housing sector.

In addition to lengthening the amortization period, the Canadian market has also been recently introduced to interest-only loans and zero-equity mortgages. Consumers can effectively borrow 103% of the value of their home because borrowers tack the cost of mortgage insurance on to the total loan value.

Mr. Tal, who is the process of compiling a report on how the new products have changed the market, says interest-only and zero-equity loans are probably less than 1% of new business. It’s the long-term amortization that has caught everybody’s fancy.

What he finds amazing about the shift towards paying off your mortgage way ahead in the future is that it has occurred almost overnight, even though this is not the first time banks have tried to attract consumers with longer amortization periods.

“They were available in the early ’80s and nobody was interested. The attitude toward debt is totally different now,” says Mr. Tal, who adds his study will show a “significant” amount of new money is geared toward that 2047 mortgage-burning party.

Those extra 15 years of mortgage debt will cost Canadians. The Canadian Real Estate Association says the average sale price of a home was $311,495 in July. If you bought that house with 0% down and a 25-year amortization, the total interest would end up being $277,993 over 25 years, based on monthly payments and an interest rate of 5.85%, a typical discounted rate today. Extend the amortization period 40 years under the same terms and you end up paying $488,116 in interest –more than the price of the house.

Paying that much interest is just throwing money away, says Ron Cirotto, who runs the Web site www.amortization.com. He has spent years trying to convince Canadians to pay down their mortgages and can’t wrap his mind around the new amortizations.

He laughs at the suggestion the 40-year amortization is giving Canadians more flexibility when it comes to making lower monthly payments. “I’m not sure you can call it an advantage to pay interest for another 15 years,” says Mr. Cirotto. “To me it’s bullshit. The best way to save money is not to have any mortgage.”

He has an answer for the people who say the only way they can buy a house is with a 40-year amortization: Don’t buy a house! “There a lot of people buying a house who shouldn’t be buying the house they’re buying. They need to buy a smaller house. People turn down their nose at smaller houses. They need to lower their expectations.”

Much of what is happening in Canada has been lender-driven, agree many in the industry. The preferential loans terms are a by-product of increased competition from mortgage insurers and financial institutions.

In Canada, anybody with less than a 20% down payment on a home (the federal government reduced the requirement from 25% earlier this year) must get mortgage insurance if they are borrowing from a financial institution covered under the Bank Act. For years, the billion-dollar mortgage insurance market has been controlled by Crown corporation Canada Mortgage and Housing Corp. and Genworth Financial Canada, but this year the federal government allowed AIG United Guaranty Mortgage Insurance Company Canada to enter the market. Two other companies have applications to join the field.

Brian Bell, vice-president of corporate development with AIG, says there is little doubt his company’s move into the marketplace shook things up. “We hadn’t seen a lot of product innovation in a long time. This [past year] was a point of time where there was a lot of opportunity to bring new products to the marketplace,” says Mr. Bell, who estimates half of the new mortgages his company insures have amortizations of 35 or 40 years.

He says in today’s market, where housing prices are up 10.6% in the first seven months of the year compared with 2006, consumers have little choice but to stretch out their mortgages. “The 40-year amortization is the only way to get people qualified.”

He doesn’t believe the new loan terms will mean Canadians buying now can expect to be finally paid off in 2047. “The average Canadian pays very quickly,” says Mr. Bell. He notes most Canadians pay a mortgage with a 25-year amortization in 12 to 14 years by increasing their payments once their incomes rise. He figures the mortgage with a 40-year amortization will probably be paid off in 20 years.

While people in “tight spots” are using the new products, Don Lawby, chief executive of Century 21 Canada, says the Canadian market bears no resemblance to the United States and its subprime scenario.

For instance, says Mr. Lawby, who also owns a mortgage company, few consumers have loans with balloon payments. These types of mortgages require almost no payments over the first couple of years, but a one-time balloon payment later on.

For people taking that type of mortgage, the hope is that prices will rise and they will cash out on their home — and pay down any debt — before any balloon payment is due. Instead, housing prices in the U.S. are falling and consumers unable to make the huge interest payments are defaulting on their loans. Because those loans were so risky to begin with, they were only sold in the U.S. subprime market, which has since imploded.

“That’s significantly different than the products available in Canada,” says Mr. Lawby. He adds even zero-equity loans with 40-year amortizations are hard to come by.

Yet, the biggest difference between the two markets is that Canadian borrowers usually plan to live in the home they buy. It’s not just an investment property.

“We’ve never seen, in my 33 years in this industry, what’s taking place in the U.S. I’ve never seen lending practices like they’ve had the past three years. Much of it was second and third investment property,” says Mr. Lawby. “We’ve lent money to people with 5% down, but we’ve been doing that since the 1970s. We’ve gone through periods where house prices dropped in 1989 to 1993. There were foreclosures but it wasn’t dramatic.”

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MORTGAGES BY THE NUMBERS

$311,495

The average sale price of a home in July, according to the Canadian Real Estate Association.

$277,993

The interest on a $311,495 house with 0% down and a 25-year amortization, based on an interest rate of 5.85%.

$488,116

Extend the amortization period 40 years under the same terms and the interest paid is more than the price of the house.

Rational

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