May 20, 2022
Reckoning has begun for borrowers who tap into their home equity
By Dale Jackson
In some markets, housing prices will fall 10-20% as mortgage rates rise to 4%: BMO
Personal Finance Columnist, Payback Time
Much of the focus on rising borrowing rates has been on how the added financial burden will affect regular mortgage payments for Canadian homeowners.
Much less attention has been on the greater impact of higher interest rates for Canadians who borrow from the equity in their homes through reverse mortgages and home equity lines of credits (HELOCs).
The posted five-year fixed reverse mortgage rate from Home Equity Bank, the primary provider of reverse mortgages in Canada, has hit an eye-popping 7.35 per cent.
Most regular five-year fixed mortgage rates, in comparison, remain below four per cent.
Reverse mortgage rates are normally higher than conventional mortgage rates; but due to the nature of reverse mortgages, higher rates will eat away at the equity in the home and compound total interest payments over time. In contrast, conventional mortgage payments lower the principal and total interest payments over time.
How a reverse mortgage works:
Reverse mortgages allow home owners aged 55 and older to borrow tax-free money against up to 55 per cent of the appraised value of their homes. Legal ownership remains with the homeowner but the amount borrowed and accumulated interest must be paid when the property is sold or transferred, or when the homeowner dies.
As the name implies, reverse mortgages are similar to conventional mortgages — but instead of payments flowing into the home, they flow out. That means instead of the principal (amount owing) falling over time, the principal rises over time.
How a HELOC works:
A home equity line of credit allows homeowners to borrow against the equity in their homes at will by simply transferring cash when they need it.
Borrowing limits can be up to 80 per cent of the home’s appraised value, minus any outstanding debt on the first mortgage.
The interest rate on HELOCs is usually tied to the prime lending rate at most banks and the difference can be negotiated. If the rate is variable, however, the principal will be extra-sensitive to interest rate increases. In some cases, a lender will offer fixed-term home equity loans over various periods of time like a conventional mortgage, but HELOC rates remain susceptible to rising interest rates whether the principal grows or not.
Equity will be eaten away at an accelerated pace:
In both cases, the combination of rising borrowing rates and the need to borrow more over time will compound the total debt burden and eat away at the equity in the home; leaving less when the homeowner moves or passes away.
Also eating away at the equity in Canadian homes are falling property values, which we are already witnessing as the Bank of Canada hikes rates in an attempt to rein in inflation.
Where this could potentially be going is alarming considering the popularity of home equity loans. They are a product of three decades of rock-bottom interest rates and haven’t been tested against the double-digit interest rates of the 1980s.
Meanwhile, the finance industry continues to find ways to tap into house-rich Canadians as they age. Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), is reportedly scrutinizing the latest home equity borrowing product called a “readvanceable mortgage,” which combines a traditional mortgage with a line of credit that increases in size as the homeowner pays down the principal.
The growing debt levels of Canadians, however, are less of a concern for OSFI (and the finance industry) than their ability to service that debt. Canadian banks are world renowned for managing risk and it is likely that home equity borrowing limits will remain comfortably below the appraised value of the home.
It’s the older homeowners sinking deeper in debt who will feel the squeeze. Under Canadian law, lenders can not confiscate a home; but as they require more cash to meet living expenses, and interest payments grow, seniors could be forced to sell to cover their loans or leave little to no equity for beneficiaries when they die.
Editor’s note: An earlier version of this column incorrectly stated the borrowing limit for a HELOC is 85 per cent of the home’s value. We regret the error.