Sunday, November 4, 2018

The Mortgage Qualification Crunch and Lower Housing Prices

Most people that have a mortgage know that interest rates have been going up over the last year and a half.  And some people with a mortgage may have heard about the B-20 rule changes that tighten mortgage qualification requirements.  However I don't think most homeowners understand how much these changes have increased the qualifying payment, which in turn significantly reduces the mortgage they can qualify for when buying a new home.
Two years ago, 5-year fixed mortgage rates were as low as 2%, and the monthly payment for a $100K mortgage was $424.  Now 5-year fixed rates are around 3.5%, and the qualifying rate would be 5.5% (3.5% + 2%).  The qualifying payment for a $100K mortgage at 5.5% is now 45% higher at $614/mth.  In terms of the house you can afford, in an extreme case of a family without any other debt service costs like a car payment, if you could afford a $500K mortgage before, now you can get a $350K mortgage.  Most families will now have to set their sights at least 25% lower than 2 years ago.

With more interest rate hikes likely coming, things will continue to get worse, although we are much closer to the end of interest rate hikes than the beginning.  Even if you weren't planning on moving into a bigger house, there will still be an impact due to downward pressures on housing prices.  That's because housing prices tend to go down as interest rates go up.  When fewer families can afford a $500,000 home, builders will make less of them.  When families move they will buy a less expensive house because they won't be able to qualify for a mortgage as big as they used to.

I don't think the impact on home prices over the next few years will be significant, with prices in most markets dropping by about 5%.  Where I think the biggest negative impact will be is in the real estate industry, with fewer homes being bought and sold.  For some people, like landlords, reductions in housing affordability is actually good news.  One of my tenants told me their plan is to buy a house in about a year.  However they had never heard about B-20, and had not met with a bank or mortgage broker to get an idea of what they can afford.  With more first-time buyers having to wait longer in order to pay down debts and save for bigger down payments, demand for rental properties should remain strong.

Friday, July 13, 2018

Advice for the small residential landlord

When I first became a landlord over 20 years ago,  I was not focused on maximizing profits.  I had other business interests, and I saw real estate as a reasonably safe and stable investment.  While renting the units did not give a large return on investment, selling them a couple years before the real estate peak in 2001 made for some healthy capital gains.  When I decided to go back to being a landlord a few years ago, I did it with no expectation of getting lucky again and riding a wave of appreciating real estate values.

What I mean by a "small" landlord is no more than 10 houses for rent.  That limit comes from the maximum number of residential mortgages banks will give a landlord.  BMO and Scotia have a limit of 10, while the limit at RBC is only 6.  Once you go over that limit, you'll only be able to get commercial mortgages, which will have a much higher interest rate than a residential mortgage.

My first piece of advice is something that applies to most business endeavors, not just property rentals.  I find many people in business are too focused on growing revenue instead of reducing costs.  I find it is easier to find a way to save $20 a month than it is to get $20 more in rent for a property.  For example, saving 0.2% on a $120,000 mortgage is $20 per month.  Rental mortgages are complicated, so the trouble of shopping around for the best rate may not seem worth it for a $20 monthly savings.  However, once you find a lender that can give you the best rate on one of your mortgages, they'll often be able to give you the best rate on your other mortgages as well.

When you are mortgage shopping, I recommend dealing with branch staff rather than brokers or bank mortgage specialists.  The reason is that the job of brokers and mortgage specialists is to bring in new clients.  Once you want to renew or make changes to your mortgage, you'll have to work with branch staff that will first have to get up to speed on your file.  My wife and I recently saved over $1000 through working with a financial services manager at BMO.  He noticed that we had a 5-year variable rate mortgage at prime - 0.5% with 4 years left.  BMO was offering a special rate of prime - 1%, and our BMO rep had calculated that with the lower rate we would save more than the 3-month interest penalty by renewing early.

Another expense that can vary greatly for landlords insurance.  Until recently our rental properties were insured by Pembridge under a residential policy along with our home and vehicles.  Most insurers have a limit of 4 or 5 rental properties before you have to go with a commercial policy.  At first it looked like we would have to pay a bit more for commercial insurance, but after a lot of shopping around we were able to find a commercial policy for less than what we were paying Pembridge.  With Pembridge, the cost of the insurance with a $5,000 deductible was around 0.3% of the building replacement value, so insurance on a $200,000 property was about $600/yr.  Our commercial Actual Cash Value policy is only 0.21% of the insured value, with an additional separate charge for commercial general liability.  Overall, it's about 10% cheaper than what we were paying under a residential policy.

Probably the most important thing a landlord does is screen tenants.  One bad tenant can turn a profitable rental business into the red.  It's also something that is probably as much art as it is science.  It should be clear that just looking for "nice" tenants is not a good idea.  You could end up with a professional tenant.  I find the best indicator of a tenant's reliability is their work history.  If they have been working full time for several years at the same company, they'll probably make a good tenant.  I ask for both work and previous landlord references, and will ask their boss specific questions that indicate reliability, such as the last time they were late for work.  Don't ask past landlords if they were a "good tenant", ask specific questions like if they ever paid their rent late, or if they even paid their rent early.  I don't waste money on screening services that charge to do credit checks on prospective tenants.  A bad tenant can have a great credit score, and a great tenant can have a bad credit score.  Many people don't realize that something as simple as refusing to pay for a cell phone billing error and switching to a new provider could take your credit score from good to poor if your old provider sends your disputed bill to collections.  Sure, they aren't supposed to send a disputed bill to collections, but you probably even have a friend or two that has had it happen to them.

My last piece of advice for small landlords is to stay out of the big markets like Toronto and Vancouver.  The return on investment for a condo in downtown Toronto will be much less than a couple townhomes in Oshawa.  Some investors think a downtown condo is a safer investment than a residential property in a small city.  Other investors like the idea of having a place in a big city where they can stay for short visits and rent out the rest of the time.   Whatever the reason, if you look at reports on rental investment returns across the country, cities like Toronto and Vancouver are consistently at the bottom of the list, while places like Halifax and London are near the top.

As for what you can expect for investment returns, 10% is a reasonable target.  That is based on putting 20% down, a mortgage with an interest rate of 3%, and a 1-2% vacancy rate.  If you are handy and can do maintenance like painting and minor plumbing repairs yourself, investment returns of 15% are achievable.  Returns of over 20% can even be made if you are in a market where you can purchase properties in need of repair that you fix up and rent.  Flipping houses may seem like the glamorous thing to do from today's TV shows, but buying that fixer-upper and renting it will make you more money in the long run.

Sunday, October 29, 2017

Tips for mortgage qualifying under the new "B-20" rules


The chart above is from the Bank of Canada's daily digest page, which shows the interest rate that is used for qualifying for most mortgage loans through Canadian banks.  What it means is that you need enough income to pay a 4.99% mortgage, even if the bank is offering you an interest rate of 2.99.  The exception to this is for people with at least 20% down taking out a mortgage with a fixed term of at least five years.  The new B-20 rules remove this exception, and will require every mortgage loan from a Canadian federally-regulated bank to test the borrower's ability to pay an interest rate that is the greater of the contract rate plus 2% or the posted qualifying rate.

The first tip is one that has already been mentioned in some financial papers, and that is to go with a 30-year amortization instead of 25.  That change will decrease your monthly mortgage payment by about 8%.  A 35-year amortization would reduce the monthly mortgage payment even more, but it's hard to find banks that still offer 35-year amortizations.

The next suggestion I have for improving your chances to qualify for a larger mortgage will help even if the B-20 rules don't apply to you, and that's ensuring the bank is using the correct numbers to calculate your debt service ratios.  I mentioned debt service ratios (DSR) in an earlier post, and listed a few things that lenders use in their formulas.  Since the formulas tend to be complicated, lenders usually will not sit down and review the numbers they are using with borrowers.  They'll pull many of the numbers from the borrower's credit bureau file, and for other numbers they'll use standard assumptions.

For responsible borrowers that pay their bills in full every month, the most significant and incorrect assumption lenders make is that you don't pay all your credit card bills.  They assume you'll make payments of 3% per month, and they'll add that 3% to your monthly debt service costs.  That means if your last credit card statement was $5000, the lender will add $150 to your monthly debt service costs.  If your last two or three statements show the balance always paid in full, that should be enough to satisfy your lender.

Another common item that adds to debt service costs are vehicle loans.  If you have a car loan that is almost paid off, paying it off early could allow you to qualify for an additional $10,000 or more on your mortgage.  If you've co-signed on a vehicle loan for a family member, the lender will use the full loan payment amount in your DSR calculations, even if the vehicle owner always makes the payments.  If the family member can re-qualify without a co-signer (or get someone else to co-sign), then you can qualify for a larger mortgage.

If you are receiving spousal or child support, ask your lender if they include that in your income.  You'll likely need to provide them with a copy of a court order to prove not only the amount you are receiving, but also to prove that the payments are enforceable in the event your former partner stops.

The last suggestion is a general one to verify the numbers that your lender is using.  In fact, even before applying for a mortgage, I recommend checking your credit report for errors and getting them fixed.  When you do apply, verify all the assumptions the lender is making are correct.  Some lenders assume average monthly heating costs of $100-$150.  That might be reasonable for an older house in PEI heated with electric baseboard, but not for a newer energy-efficient home in Alberta where natural gas prices are close to the lowest in North America.

Sunday, October 1, 2017

The Mysteries of Rental Debt Service Calculations

In my post on residential mortgages, debt service calculations for an owner's primary residence were relatively simple to explain.  With rental properties, just trying to understand debt service calculations for can be quite perplexing.  And even if you can understand the calculations, there are quirks in the formulas that don't seem to make much sense.  At least lenders tend to use the same GDS and TDS limits for rental properties as they do for a primary residence.  For GDS that is 32-35%, and 42-44% for TDS.  Unlike the rules for CMHC-insured mortgages, these debt service limits can be exceeded depending on the overall strength of the application.

I'll start with the calculations for someone making their first rental property purchase.  BMO, CIBC, and Scotia all seem to follow CMHC's rules for calculating GDS, even though CMHC does not insure single-unit rental properties.  This means that to calculate Gross Debt Service ratio, half of the rental income will be added to the purchaser's income, then the principal and interest will be divided by that sum.  To calculate Total Debt Service ratio, it is necessary to add the purchaser's other debt service costs, such as primary residence mortgage payment and car loan.  In the spreadsheet above (google docs link) I've done the calculations for someone making a salary of $50,000 per year, with principal, interest, and taxes on their home of $850 per month, and no other debt service costs.  The rental property is being purchased for $200,000, and it rents for $1400 per month with all utilities paid by the tenant.  The results indicate a very low GDS of 19%, and a modest TDS of 36%.

Once more than one rental property is involved, the calculations become much more complicated.  Most lenders use a rental offset calculation for the rental properties you already own, while some (like CIBC) will use Debt Service Coverage Ratio.  Rather than explain the full details here, this Moneysense article does a good job explaining the two.  The spreadsheet above shows a second rental property mortgage for $160,000 with the same $1400 in monthly rent.  The 50% rental offset used by Scotiabank results in a slight increase in TDS from 36% to 38%.  BMO uses a more generous 85% rental offset, which results in a reduced TDS of 34%.

Finally, I'll show how the ratios change for purchasing a 2-unit rental property with a mortgage of $320,000 instead of purchasing two single-unit properties.  If you expect the ratios to be similar, you are in for a surprise.

The GDS has increased from 19% to 33%, and the TDS has gone up to 48%, well above the limits of any banks.  Unless I've made a mistake in my calculations, this means that it is much easier to get two mortgages for $160,000 than it is to get one mortgage for $320,000.  I'd expect banks to prefer one mortgage for $320,000, since processing and administering two mortgages is a lot more work for them.  I doubt lenders will change their rules for debt service calculations, since it is a lot easier for investors to purchase their properties one unit at a time than it is for a large bank to change their underwriting rules.

2017-10-02 Update: I had a conversation with a Scotiabank home financing advisor, and found out that they don't count taxes in their rental offset calculations.  That means the TDS when purchasing the 2nd rental unit would be 36% instead of 38%.

2017-11-18 Update: A TD mortgage advisor recently informed me that they, like CIBC, use a Debt Service Coverage Ratio.

Monday, September 18, 2017

Residential mortgages in Canada


Almost everyone who buys a house in Canada takes out a mortgage.  Most people, however, don't understand how lenders calculate how much you can borrow, and a large number of people don't even shop around for the best mortgage rate.  I'll explain in simple terms how to calculate how much you can borrow, and how to get a good rate.

Lenders use formulas to calculate debt service ratios from your housing costs and your income.  The housing costs lenders look at are your mortgage payment, your property taxes, and sometimes heating.  Lenders require the housing costs to be less than about a third of your gross (before tax) income.  With a bit more math, you can calculate how much of a mortgage you can get based on your income.  In general, that will be about four and a half times your income, or close to five times your income with some lenders if you have very good credit.  In other words, a single person making $40,000 per year would be able to borrow between $180,000 and $200,000.

Ten years ago I used to recommend people looking for a good rate on their mortgage deal with a mortgage broker.  The brokers could check with the big five banks and other lenders to find the best rates.  Now CIBC and BMO do not work with brokers, and Scotia sometimes will not offer their best deals through a broker.  Therefore I recommend going to three of the big banks when shopping for a mortgage, and try to find someone that does a lot of mortgages, since they are usually the ones who know how to get the best rates.  Also disclose the fact that you are shopping for the best rate and will be applying at one or two other banks.  If you don't tell the lender that you expect a great rate, you probably won't get it.  Ask local real estate agents, lawyers, or financially astute friends who they recommend for getting the best rates on a mortgage.  Mortgage comparison sites can be helpful too, however most of them are really advertisement sites that only show paid listings.  One site I trust is Rate Spy, which doesn't restrict its mortgage listings.

For people who are putting less than 20% down and therefore need mortgage insurance, I still recommend using the services of a good broker (although finding a good broker can be a bit difficult).  In the last couple years non-bank lenders have started offering better rates on insured mortgages because of the lower risk to the lender when mortgage is insured against default.  Many of these non-bank lenders only work through brokers, hence the need to use the services of a broker.  Brokers and credit unions are also the best option for people with below average credit that may not be able to qualify for a mortgage at the big banks.

For people who want more specific advise, I recommend applying with BMO and Scotiabank and asking for their best rate on a 2 year fixed mortgage.  Over the past year, at least where I live in Nova Scotia, they have had the best mortgage deals.  Even when TD or Royal has had lower advertised special rates, BMO or Scotia have been able to beat them.  Don't apply to just one of them, since sometimes BMO will offer rates that Scotia can't beat, and sometimes Scotia will offer rates BMO can't beat.

Monday, July 3, 2017

Be your own agent


What I'm about to write about would be considered heresy by some real estate agents, but I'm not one to just go with the flow.  When buying a house, you can save 2-3% by forgoing what is known as a buyer's agent, and dealing with the listing agent directly.  You'll probably have a smoother purchase process too.

In the US and Canada, depending on the market you live in, commissions paid to a buyer's agent are often 2-3% of the sale price.  Unscrupulous people in real estate will claim the buyer does not pay those commissions, but ultimately they do.  When working directly with a buyer, most listing (seller's) agents will discount some or all of the buyer's agent commission, which reduces the price you pay for the house.

Decades ago it was necessary to have a buyer's agent because they had access to the real estate listings.  Now most buyers find the properties they are interested in on their own, and only use an agent for viewing the property and as an intermediary in the purchase negotiation.  The listing agent is actually the best person to show the property, since they know the property from preparing the listing.  Having one less cog in the wheel also makes the process run smoother, and can even make the difference between getting the property you want and missing out.  When you have a buyer's agent, your interest in making an offer may not get communicated to the listing agent for several hours, and if another offer was accepted or countered during that time, you could loose the opportunity to purchase the house.

Some jurisdictions still allow dual agency, where one agent acts for the seller and the buyer, and collects the full commission.  So when you contact the listing agent, tell them you want to work without anyone acting as your agent.  In Nova Scotia, the legal term is that you are working as a "customer" and would sign a "buyer customer status acknowledgement".  People in the industry may try to scare you by pointing out that you don't have someone legally required to put your interests first, but you are still legally protected.  Due to both professional standards for licensed agents and laws regarding fraudulent sales, the listing agent has to tell you all the details of the property, both good and bad.

Before asking to see a property, one of the first things you should ask the listing agent is the commission "to the street", so you know how much would be going to a buyer's agent if you had one.  Then ask if they cut their commission to the seller by that amount if you don't have an agent.  I questioned five agents in my area, and three were willing to work directly with a buyer while cutting the full 2.5% commission off the purchase price.  One agent was willing to work directly with a buyer but would not confirm if they would forgo the 2.5%.  The fifth said they were not comfortable working directly with a buyer, and so would require them to have their own agent.

So while being your own agent may not be an option all the time, when you can save 2-3%, I think it is worth trying.  Good luck on your next real estate purchase!