Housing developers are lobbying Ottawa for tax changes that would allow buyers of new homes to deduct mortgage interest from their taxable income. Under Canada’s Income Tax Act, homeowners can deduct mortgage interest for rental properties, but not for their principal residences.
The proposal is loosely based on the U.S. mortgage interest deduction. In the U.S., homeowners who itemize their taxes can deduct interest paid on up to $750,000 of mortgage debt, or $375,000 for married couples filing separately. The trade-off is that the U.S. tax system can tax capital gains on the sale of a principal residence above certain exclusion limits.
Economists have long criticized the U.S. mortgage interest deduction. The deduction is intended to encourage homeownership, but research suggests it can instead encourage people to buy larger houses. A 2018 paper argues that the deduction can actually reduce homeownership by driving up home prices, as some of the benefit is capitalized into the value of a home.
The current proposal aims to address affordability by reducing the after-tax cost of mortgage payments, with the potential tax cost ultimately recovered through the treatment of capital gains on the sale of the property. But there may be a simpler way to tackle affordability without making the tax system even more convoluted.
Rethinking the mortgage stress test
A key deterrent for first-time homebuyers is the mortgage stress test. Federally regulated lenders must qualify borrowers at the higher of 5.25 per cent or the mortgage rate plus 2 percentage points.
In the current interest-rate environment, the stress test can encourage borrowers to choose variable-rate mortgages because they may qualify for a larger mortgage at a lower qualifying rate. But this can leave borrowers exposed to the risk of rate shocks, as many borrowers experienced during the Bank of Canada’s rapid rate-hiking cycle from 2022 to 2023, when the policy rate rose from 0.25 per cent to 5 per cent.
One alternative would be for Finance Canada to exempt 10-year mortgage terms from the stress test. This could create a new avenue for financing first-time buyers while giving borrowers greater certainty around their borrowing costs.
The spread between five- and 10-year Canada Mortgage Bond (CMB) rates is currently around 42 basis points. However, for this difference to translate into more competitive 10-year mortgage rates, changes to the Interest Act would likely be required.
Under current rules, once a 10-year mortgage has been in place for five years, the borrower can repay it early with a penalty of only three months’ interest. Shorter-term mortgages can be subject to the greater of three months’ interest or an interest rate differential (IRD). An IRD is intended to compensate lenders for the financial loss they may incur when a borrower repays a mortgage early and the lender has to re-lend the funds at a lower market rate.
Exempting 10-year mortgages from the stress test would likely mean first-time buyers committing to a longer-term mortgage. The benefit would be greater certainty around their financing costs and the ability to qualify without the stress test. The downside is that borrowers could face higher borrowing costs over the 10-year term if market rates subsequently fall.
From a regulatory perspective, however, a 10-year term could provide enough time for borrowers to pay down principal and build equity, reducing the risk associated with refinancing at renewal.
There is another challenge: 10-year CMB funding is not widely used by residential mortgage lenders because many do not have offsetting products or a sufficiently broad balance sheet to manage any resulting funding mismatch. Finance Canada would therefore need to ensure that a portion of 10-year CMB issuance was earmarked for this type of lending.
If the program proved successful, the government could also consider increasing its size.
This approach would not be a universal solution. Its effectiveness would depend on market conditions, and a longer mortgage term would not necessarily be the right choice for every borrower. But it could provide a source of financing for first-time buyers without adding another layer of complexity to Canada’s tax system.
If the objective is to improve housing affordability, this could be a simpler and less costly approach than changing tax policy.
Independent Opinion
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