Much of the focus on rising borrowing rates has been on how the additional financial burden will affect the regular mortgage payments of Canadian homeowners.
Less attention has been given to the larger impact of higher interest rates for Canadians who are borrowing equity in their homes through reverse mortgages and home equity lines of credit (HELOCs).
A five-year fixed-rate reverse mortgage from Home Equity Bank, the leading provider of reverse mortgages in Canada, posted a staggering 7.35 percent.
By comparison, most five-year fixed mortgage rates remain below four percent.
Reverse mortgage rates are usually higher than traditional mortgage rates; But due to the nature of reverse mortgages, higher rates will eat up the home equity and compound gross interest payments over time. In contrast, traditional mortgage payments reduce principal and gross interest payments over time.
How does a mortgage work:
Reverse mortgages allow homeowners 55 and older to borrow tax-free money for up to 55 percent of the appraised value of their homes. Legal ownership remains with the homeowner but the amount borrowed and interest accrued must be paid when the property is sold or transferred, or upon the homeowner’s death.
As the name implies, reverse mortgages are similar to traditional mortgages – but instead of payments flowing into a home, they flow. This means that instead of the principal amount (the amount owed) decreasing over time, the principal amount rising over time.
How does HELOC work:
A home ownership line of credit allows homeowners to borrow against equity in their homes at will by simply transferring cash when they need it.
Borrowing limits can be up to 85 percent of the home’s appraised value, minus any debt owed on the first mortgage.
The interest rate on HELOCs is usually linked to the prime lending rate at most banks and the difference can be negotiated. However, if the rate is variable, the capital will be more sensitive to an increase in interest rates. In some cases, the lender will offer fixed-term home equity loans over different time periods like a traditional mortgage, but HELOC rates remain subject to higher interest rates whether or not the capital grows.
Equity will be eliminated at an accelerating pace:
In either case, the combination of increased borrowing rates and the need for more borrowing over time will double the overall debt burden and erode the home’s equity; Leave less when the homeowner moves or dies.
The erosion of equity in Canadian homes is also driving down property values, which we are already seeing with the Bank of Canada raising interest rates in an attempt to rein in inflation.
Where this could go is worrisome given the popularity of home purchase loans. It is the product of three decades of extremely low and untested interest rates against the double-digit rates of the 1980s.
Meanwhile, the finance industry continues to find ways to take advantage of wealthy Canadians as they get older. The Canadian banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), is said to be scrutinizing the latest home equity borrowing product called the “adjustable mortgage,” which combines a traditional mortgage with a line of credit that grows in size as the homeowner pushes down the principal.
However, Canadians’ increasing debt levels are not of concern to OSFI (and the finance industry) about their ability to service this debt. Canadian banks are globally renowned for their risk management and equity borrowing limits are likely to remain comfortably below the appraised value of the home.
It’s the older homeowners who are drowning in debt who will feel the pressure. Under Canadian law, lenders may not forfeit a home; But as they need more cash to cover living expenses, and interest payments increase, seniors may have to sell to cover their loans or leave little or no equity to beneficiaries when they die.