Dale Jackson

Personal Finance Columnist, Payback Time

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This week’s news that Canadian households have fallen deeper in debt than any other G7 country is setting off alarm bells.

According the Canada Mortgage and Housing Corporation (CMHC), the amount we owe has surpassed Canada’s entire growth domestic product (GDP).        

But that’s not the half of it. Three quarters of Canadian household debt is tied to mortgages; either directly or through home equity loans. 

CMHC, the country’s largest mortgage insurer, says ballooning debt levels have made the Canadian economy vulnerable following a series of interest rate increases in just over a year, which have in some cases doubled regular mortgage payments for homeowners.

Much less attention has been on the greater impact of higher interest rates on 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 astonishing 7.5 per cent compared with 4.5 per cent for conventional mortgages.

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 homeowners 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 higher 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.

Home equity could be further eroded if rates continue to rise and/or the value of the property falls.

LEVERAGED HOMEOWNERS WILL SUFFER IN SILENCE

The concern from the CMHC and other government and finance industry interests only go as far as the “systemic risk”, or risk to the entire financial system in the event of mass default. They actually benefit from higher debt levels as long as borrowers have the ability to service it through regular payments.

In fact, when the economy tanks HELOCs save far more people from credit defaults than they cause, which helps stabilize the financial system during crises.

That systemic risk goes away with home equity loans because the debt is secured by the collateral in the property and regular payments are not required.

Many older homeowners will feel the squeeze alone as they sink deeper in debt and watch their home equity erode faster than it appreciates. 

Under Canadian law, lenders can not confiscate a home; but as leveraged homeowners require more cash to meet living expenses, and interest payments grow, they could be forced to sell to cover their loan or leave little to no equity for beneficiaries when they die.