On Jan. 1, 2018, Canada imposed the B-20 mortgage stress test policy, a tougher renewal or refinancing mortgage rules where borrowers should prove that they can pay higher interest rates, even higher than the rates stated within their contracts.
The stress test includes even those borrowers who were able to pay 20 percent down payment for the property they are buying. Previously, the stress test only applied to those who can only afford lower down payments.
While the B-20 is not applicable to borrowers who would renew mortgages with their current lender, most of the banks now have rising interest rates that borrowers could no longer afford.
With this situation, more loan applications have been declined by banks and a growing number of borrowers have turned to private lenders.
“Private lenders” are normally groups or firms that pool money from wealthy individuals who have enough capital to issue loans. Private lending, meanwhile, is defined by the Financial Stability Board as “the extension of credit from entities or activities which are outside the regulation perimeter for banks.”
Economists estimate that private lenders now accounted for about one-tenth of Canada’s $1.1 trillion mortgage market. And while this remained minute compared to the market share of the big banks, the growing number of borrowers who prefer private lenders is now a cause for worry.
The situation has, in fact, reached an alarming level that officials at the Department of Finance’s Senior Advisory Committee have reportedly discussed possible measures on how to regulate the operations of private lenders. The meeting was headed by Paul Rochon who is serving as deputy minister of finance for Finance Minister Bill Morneau, according to unnamed sources who spoke with Reuters. Attendees of the meeting included officials from the Bank of Canada, OSFI and the Canada Mortgage and Housing Corp., the sources told Reuters exclusively.
The problem with private lenders
Officials are worried that private lenders may charge borrowers with higher interest compounded rates which would only bury people in a mountain of debts.
For instance, private lenders, who are also sometimes referred to as shadow lenders, could lend up to 90 percent of the property’s value and then charge the borrower with annual rates that are between 10 percent and 20 percent higher than the 3 to 5 percent offered by banks.
While the market share held by these private lenders are still nominal, the rate of how fast they have grown in the past year alone should sound the alarm, according to Benjamin Tal, the deputy chief economist at CIBC World Markets.
Private lenders now accounted for 8.7 percent of Toronto’s residential mortgage at the end of June 2018, a 5.9 percent increase compared in the previous year.
“This could have macro-economic significance. Over 10 percent, in my opinion, is already too big and, without regulation, private lenders can grow to more than 15 percent, which is too strong,” Tal said.
How to stop the growth of private lenders?
Most of those resorting to borrowing money from private lenders are self-employed people who report little income or who could be perceived by banks as individuals without a stable source of finances. Individuals who have recently undergone a divorce and those with poor credit scores also accounted for a large chunk. These are the individuals who are also normally being turned down by banks.
The number one solution being considered by officials is to bring these private lenders under federal supervision, a move that will require a change in the law, according to Reuters. Under the federal government, these private lenders could also be required to implement the B-20 guidelines on their clients.
Another option being looked into is for provinces to oversee that private lenders under their jurisdiction implement tougher background checks to ensure that borrowers could really repay the loans they are giving them.
Canada’s home market continues to decline
While the government is sounding the alarm against private lenders, different housing market data are seemingly telling a different story.
Recent economic research released by RBC said it expects soft sales to worsen in 2019 as home buyers are burdened by rising interest rates and the mortgage stress test.
“Our view is that these factors will keep home resale relatively flat in Canada in 2019 with a gain of less than 2%. These factors will also significantly constrain buyers’ purchasing budgets,” RBC wrote in the report.
Statistics released on Jan. 15, 2019 by the Canadian Real Estate Association also reflected the same weak results. The report highlighted that national home sales decreased 2.5 percent from November to December 2018. The number of newly listed homes also showed little changed from November to December, meaning a few are buying.
“This decline, in part, is due to elevated activity posted in December 2017 as home buyers rushed to purchase in advance of the new federal mortgage stress test that came into effect on January 1, 2018,” the report said.
Gregory Klump, CREA’s Chief Economist, mentioned that the Bank of Canada expects weak housing activity to continue this year as households endure the mortgage stress-test and increased mortgage rates.
“Indeed, the Bank’s economic forecast shows it expects housing will undermine economic growth this year as the mortgage stress test has pushed homeownership affordability out of reach for some home buyers,” Klump said.