BUSINESS
05/12/2019 11:55 EDT | Updated 05/13/2019 10:16 EDT

Interest-Only Mortgages Have Come To Canada, But Do We Really Need This ‘Innovation’?

Canada's "boring" financial system kept us out of trouble during the financial crisis. Now they want to make things interesting. Uh oh.

This year, nearly a million Australian homeowners are facing a nasty reality: Their monthly mortgage payments are spiking, overnight, by an average of $400 per month.

It was the latest dump-truck delivery of salt into the open wound that is the Australian housing market, now in a historic slump thanks to unaffordably high prices and the disappearance of foreign buyers.

While that might sound familiar to Canadians, this latest shock to Australia's housing market was brought about by something Canadians largely aren't familiar with: Interest-only mortgages. It's a type of loan that's popular Down Under, in the U.K. and elsewhere, where borrowers pay only the interest on their mortgage for some set period of time, commonly four or five years.

Watch: Empty Vancouver mansions make for sweet student crash pads. Story continues below.

That's right, you make mortgage payments, but the principal you owe doesn't come down at all. The upshot for borrowers is that, in those first years of the mortgage, they make far smaller monthly payments than they would with a traditional mortgage.

But then, of course, comes the day when the interest-only period expires, and your payments jump to include repayment of principal. That's what's happening to 900,000 Aussie households this year. The government in Canberra estimates that, at current interest rates, Aussies with interest-only loans will pay nearly $100,000 in additional interest payments on a $750,000 house, in the long run.

If that sounds like a risky proposition to you, you're right. Back in 2002, U.S. lenders created something similar to an interest-only mortgage, a 30-year "adjustable rate mortgage" that gave homebuyers a very low "introductory rate" for the first five years, followed by a hefty spike in the rate, and with it, much larger monthly payments.

Five years after those ARMs were introduced, mortgage payments soared, helping to trigger the U.S.'s financial crisis. All of this is neatly explained in the 2015 movie, "The Big Short."

Earlier on HuffPost Canada:

Interest-only mortgages disappeared from Canada's prime mortgage market in 2010, in the wake of the U.S.'s debacle. But now they're back, with mortgage company Merix Financial becoming the first Canadian lender to reintroduce the product last year, a 30-year "interest-only flex mortgage."

Does that sound like a good idea? To Bank of Canada governor Stephen Poloz, it might. He gave a speech last week in which he urged Canada's financial sector to create new mortgage products as a way of reducing the risk from high household debt.

In essence, his argument was that more different types of mortgages would spread out the risk of a debt crisis. If everyone has the same type of mortgage, everyone is susceptible to the same risks, so if something goes wrong. everyone's up the same creek without a paddle. More varied mortgages would mean any negative scenario would affect fewer people.

Graham Hughes/The Canadian Press
Bank of Canada Governor Stephen Poloz speaks during a business luncheon in Montreal, Thurs. Feb. 21.

But should interest-only loans be part of the solution? Robert McLister, founder of mortgage site RateSpy.com, says they wouldn't pose the type of risk in Canada that they do in some other places, in part because the mortgage "stress test" applies to them, limiting how much people can borrow.

"Interest-only mortgages are generally harder to qualify for," McLister said in an email to HuffPost Canada. "Unlike the irresponsible U.S. variety, pre-housing crash, Canadian (interest-only mortgages) do not increase your buying power."

For that reason, McLister believes "they'll never be mainstream in Canada."

Few borrowers would benefit

Interest-only loans make sense for only a small fraction of homebuyers, McLister says. For instance, if you're a small business owner who needs cash to get their company running, it may make sense to lower your mortgage payments and put the difference into your business.

"In limited cases, they're also sometimes suited to people with temporary cash flow concerns — families going on maternity leave, people with irregular or seasonal income, etc. But these applications make me a bit more nervous," he wrote.

Securitized mortgages: another blast from the past

In his speech, Poloz also suggested that Canada expand the "securitization" of mortgages. This means lenders bundling the mortgages on their books into a single "security," then selling it to investors who collect the income from mortgage payments. This process is invisible to borrowers, who keep paying the bank every month.

This would give lenders new sources of funding that would reduce costs to borrowers meaning lower interest rates on mortgages. But guess what? This idea also helped crash the U.S. economy a decade ago.

When those ARM payments shot up in 2007, it turned out that a lot of those "securitized" mortgage bundles were not worth anywhere near what investors paid for them. The borrowers couldn't afford to make those mortgage payments, so there was no revenue stream. The mortgage bundles turned out to be essentially worthless little pieces of paper. That was a major trigger of the financial crisis.

"Unlike the irresponsible U.S. variety, pre-housing crash, Canadian (interest-only mortgages) do not increase your buying power."Robert McLister, RateSpy.com

For that reason, Poloz is urging "transparency" in mortgage bundling, which already goes on in Canada to a limited extent, backed by Canada Mortgage and Housing Corp. He wants to set up "a public database of mortgages used in securitization," where a borrower's identity would be kept secret but details of their financial circumstances would be available.

As the debt crisis unfolded a decade ago, many experts noted that Canada remained relatively unscathed. They credited the country's "boring" financial system, with its lack of exciting new ways to borrow, for keeping the economy afloat.

Poloz's speech this week suggests he wants to change that.

"There are many other possible variations on mortgage design ... that it makes me wonder why so little has happened in our mortgage market in my lifetime," the Bank of Canada governor declared.

"To be clear, the system is not broken — it has served Canadians and financial institutions well. But we should not stop looking for improvements."

Given recent history what happened in the U.S. a decade ago, and what's happening in Australia today can you blame Canada's lenders for largely sticking to the tried and true?