Do You Feel Like Gambling?

Perhaps that should be the questions mortgage brokers and banks ask potential homebuyers before they offer interest-only mortgages. Now, although interest-only mortgages are old news in the U.S., in Canada they are a fairly recent development in the lending business, coming online three short months ago.

In the U.S., interest-only mortgages were intended primarily for high net-worth consumers who wanted to use principal payments on their million dollar mortgages for investing into, among other things, capital markets. But, as was the case with most good “deeds” before, this one also had to be “punished” by being overused. In the end, everyone thought interest-free mortgages were just the thing for their homes, which had to be remodeled, expanded, what have you.

Now, it is too early in the game to say whether Canadians have yet been taken in by the concept, although so far, not many institutions are offering interest-only mortgages. By the same token, those that are cannot say to have done much in terms of marketing. Regardless, in spite of receiving the green light from the Canada Mortgage and Housing Corporation, (CMHC), the appearance of interest-only mortgages signals only one thing– Canada’s real estate market could be heading towards a correction similar to the one we are seeing in the U.S.

Earlier this week, the U.S. National Association of Realtors came out with some disturbing numbers. For example, August saw the lowest sales of existing homes since early 2004. In addition, year- over-year, prices hit the lowest levels since April of 1995. The U.S. real estate market has already hit the soft patch, and Canadians should not be surprised to see a similar correction happening here as well.

Where do interest-only mortgages come into play with real estate market softening? Simply, it is the question of affordability. Interest-only mortgages are no longer a tool for rich homeowners to free up money for capital investing. Rather, it has become a way for many people to afford a house, barely!

Last month, an average price of a house on the national level was CDN$277,189. However, prices in urban centers, such as Toronto, Calgary and Vancouver, averaged between CDN$338,192 and CDN$520,686. In contrast, incomes are not even remotely keeping up the pace. This discrepancy is what is making buying homes less affordable.

Furthermore, interest-only mortgages are also a sort of a resuscitation method of last resort for the housing boom. If people have smaller mortgage payments, they could be more inclined to keep on buying houses. To illustrate, if you have an interest-only mortgage for five years on a home worth CDN$200,000 and at the interest rate of 5.3%, you would have to pay only about CDN$825.00, versus about $1,200.00 in regular mortgage payments. With interest-only mortgages, potential homebuyers can also afford loans with higher interest rates, the result of which could be hoards of people buying homes that are simply too expensive for their pockets.

Now, in a market where house prices are rising, this may not be such a big deal. Even if no principal is being paid off, the rising housing market is building up your equity. However, it is a completely different story in a stagnant or declining market. So, for anyone out there contemplating interest-only mortgages, ask yourself first how exactly do you feel about gambling your house away?