Over the past 50 years, the housing market has introduced various mortgage products to address a range of challenges faced by homebuyers. This article reviews some of these offerings.
Current mortgage products are relatively homogeneous. Most are fixed-rate payment products where both the rate and payment amount are fixed, or where the rate can vary but the payment remains constant.
In the 1980s, as today, homebuyers faced an affordability crisis. Back then, the primary driver of the crisis was double-digit interest rates, which increased the cash flow burden of mortgage payments, rather than home prices. The combination of high inflation and level-pay mortgages made it difficult for households to afford homes that fit their long-term income and consumption levels. Today, the problem with mortgage design is that it places an unnecessarily high payment burden on borrowers.
Instead of attempting to raise incomes or bring down house prices, we should offer homebuyers and homeowners different types of mortgages.
Price-level adjustment mortgages
In the 1980s, the Canadian government introduced price-level adjustment mortgages for housing cooperatives. (Instead of owning individual units, residents purchase shares in a cooperative, which gives them the right to occupy a specific unit and participate in the management of the property.) These mortgages provided payments that were constant in real terms (i.e. when adjusted for inflation). Because defined-benefit pension plans have liabilities that grow with inflation, these mortgage products were primarily purchased by insurance companies.
Dual-index mortgages
In Mexico, dual-index mortgage products were developed by SOFOLES, a financial intermediary established to support mortgage lending to low-income households. These products have payments tied to a salary and wage index, while the payment to the lender is based on an interest rate index. This design aims to protect against inflation. However, if the indexes do not align, there may be remaining unpaid principal balances at the end of the loan term. To mitigate this risk, the government provides insurance to the lender.
Wage-indexed mortgages
Since inflation is not the main driver of the current affordability issue, price-level adjustment and dual-index mortgages are likely not the right solutions for our market. However, there may be potential in indexing mortgage payments to wage growth. Typically, wages increase over the life of a mortgage, so structuring payments to align with wage growth could help maintain affordability. This concept was used in Turkey in the early 2000s with wage-indexed mortgages.
Interest-only mortgages
In Denmark, interest-only (IO) mortgages were introduced in 2003. With IO mortgages, borrowers could defer amortization payments for up to 10 years, which initially reduced mortgage expenses by about 20% annually for the first ten years compared to fixed-rate mortgages. In Denmark, mortgage banks (originators) are fully liable for defaults on the mortgages they sell to investors, mitigating concerns about asymmetric information in the mortgage market. During the financial crisis, Denmark’s default rate peaked at just 0.6% of outstanding mortgages. However, Denmark also saw a larger housing boom than most other countries over this period. While IO mortgages may benefit initial homebuyers, they risk creating excess demand pressure in the market, potentially crowding out future homebuyers.
Graduated payment mortgages
Another solution is a graduated payment mortgage (GPM), a fixed-rate mortgage with an amortization schedule that starts with lower payments, which gradually increase over time. The purpose of this type of mortgage is to allow homeowners to begin with lower monthly payments. In the US, the Federal Housing Authority offers GPMs that can be structured as:
- A 5-year initial period with payment increases of 2.5%, 5%, or 7.5% annually
- A 10-year initial period with a 2% annual increase
With GPMs, the loan balance initially increases before it begins to decrease. This happens because the early payments may not cover the full interest cost, leading to negative amortization.
While GPMs offer the advantage of lower initial payments, which can make it easier for borrowers to qualify for a mortgage, they have higher overall costs, complexity, and the risk of negative amortization. The product relies on the assumption that the borrower’s income will grow over time. In Canada, when GPMs were introduced in the past, lenders were hesitant to offer them. The current mortgage stress test may also limit the flexibility needed for borrowers to qualify for these products.
CMHC has explored a number of these solutions to address affordability challenges in the past. It might be time to revisit the archives to see what past solutions might work today. While implementing these solutions on a national level might increase demand and potentially be counterproductive, they could be effective if applied to specific, targeted borrower segments.
Independent Opinion
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