There is a lot of confusion over the “Credit Crunch” or “Mortgage Crisis”which is apparently sweeping the globe. I’ll do my best to simplify and summarize the US problem and explain why it won’t ever happen in Canada.
2007 saw the United States facing crashing real estate markets and a record high number of home foreclosures. Many families have lost their homes and many more have lost equity they had built up in their homes. This has been referred to as the “sub-prime crisis.”
The first thing we need to clear up is the meaning of the term “sub-prime.” Sub prime lending refers to the practice of granting mortgages to less than ideal candidates, usually those with poor credit or past bankruptcies. These clients pay a higher rate and usually upfront fees for the privilege of borrowing money. The term “prime rate” is the interest rate charged by banks to their most creditworthy customers; “sub prime” is not related to this term and does not meaning customers getting a lower rate than the “prime rate.”
Now, lets move on to the cause of the mortgage crisis south of the border. While this is not intended to be a social commentary I couldn’t explain the problem without first discussing the obvious. The United States is a country of over-indulgence. Marketers push food, clothes, cars and homes on people that they don’t need and creditors make it easy for the customer to give into their craving and just spend without recourse. The average consumer spends more than they make. I’m a mortgage planner not a financial advisor, but this seems like bad financial planning to me.
Ok, so I’m getting sidetracked here. Well what happened in the US is that the housing market was booming and so lenders decided to grant people mortgages they couldn’t really afford. The way mortgage qualification works is that your monthly mortgage payment can’t be more than xx% (usually 32-35) of your pre-tax income; this is to ensure you’ll be able to afford to eat and get to work while making your mortgage payments. Some lenders down south started pushing what are know as “graduated payment mortgages” on people and this is where the problem started.
Graduated payment mortgages, or GPMs were originally created to help low income families secure housing and were usually run through the government. While in a normal mortgage your payment is the same in year 25 as year 1, in a GPM your payment gradually increases (as it is assumed your income will as well). The low initial payments let those with a low income qualify for a mortgage they otherwise wouldn’t be able to afford. This can be great for lower income families trying to get back on their feet. The problem with GPMs is that your initial small payments usually don’t cover the interest accrued on your mortgage, so the amount you owe actually increases each month.
When the US housing market starting to boom in the early 2000s many private lenders started pushing GPMs with teaser rates (very low rates of one or two percent interest for a short period of time). These mortgages weren’t aimed at struggling families, instead they were used by the middle class. John and Jane would get a GPM to buy the biggest possible house they could, then use the money they saved from their teaser rate to buy a new BMW and send the kids to private school. Because the markets were hot the banks and the borrowers assumed their house would keep going up in value and wasn’t concerned that their mortgage was actually increasing in value.
So what happened? Well the markets started to turn. Now John has a $425,000 mortgage on a house he paid $415,000 for that is now worth $325,000. Because he took only a 3 year term for the teaser rates his mortgage comes due before the market has time to pick itself up and no one will refinance his house (remember he owes $425,000 and his collateral is now only worth $325,000). John can’t refinance, the bank takes his house and is force to foreclose. Soon enough this happens 3 times on the same street and property prices tumble, everyone knows the story from this point.
WHY THIS WON’T HAPPEN IN CANADA
This simple answer is that the banking system is Canada is one of the best in the world, and the sub prime market in Canada is minuscule compared with the United States. GPMs are almost never offered here, and Canadian consumers are much smarter about their credit and spending. I was recently speaking with an executive at a major lender with operations in both the United States and Canada who commented on how amazed he was at the low rates of foreclosure in Canada and especially BC. Canadians have enormous pride in home ownership and paying their bills on time.
If you’re knowledgeable on the subject feel free to add to this article. I’m not an economist or an expert on the subject.
For more on the US housing mark and foreclosures this article offers some excellent commentary and links to other sites:
http://wallstreetexaminer.com/blogs/ducalion/?p=127
