The persistence of Toronto’s red hot real estate market has left many HomeBuyers wondering if things are ever going to slow down. The US real estate market has been slowing down for some time now, so why isn’t Toronto’s market following suit?
The slowdown in the US real estate market is, for the most part, a by-product of the collapse of its subprime mortgage market. Subprime mortgages are high-risk mortgages geared towards HomeBuyers who, because of bad credit or unsatisfactory financial situations, don’t qualify for a mortgage with traditional lenders. Subprime mortgages have a higher interest rate and higher fees than traditional mortgages. Both the US and Canada have subprime mortgage markets, but what differentiates them is relative weight; in the US, subprime comprises about 20 percent of the total mortgage market, while in Canada, subprime accounts for about 5 percent. The U.S. industry is also unique in the predatory manner in which it targeted low income earners, visible minorities and immigrants to sell its high cost products.
The problems with the US subprime mortgage market were further compounded by a tricky little mortgage called an Adjustable Rate Mortgage (ARM). ARMs typically featured lower interest rates and lower mortgage payments than traditional mortgages. What many HomeBuyers didn’t realize was that these low interest rates were only good for a short period of time. During the term of the mortgage, a HomeOwner’s interest rate would be adjusted from the introductory rate to an interest rate at, or, in many cases, above, the market rate. Similarly, the low mortgage payments HomeBuyers were quoted were also on offer for a limited time only; they would be adjusted to a higher mortgage payment at some point during the term of the mortgage.
But changing interest rates and mortgage payments mid-term – in many cases, without properly informing HomeOwners about the possibility of changes before they signed on the dotted line – was not the only problem with the ARM. ARM mortgages allowed for something called negative amortization. Negative amortization is when a borrower pays less than the full interest amount owed to their lender each month, and sees the difference owed added on to the total loan amount to be paid off. Have I lost you? Let’s try an example.
Suppose a HomeBuyer named Sue is about to get a $200,000 mortgage with a $1,200 monthly mortgage payment. Just before she signs for the mortgage, a fast-talking Mortgage Broker approaches her and tells her that she can get a $200,000 ARM mortgage with a monthly mortgage payment of only $700. Like most HomeBuyers, Sue thinks that the idea of saving $500 a month on her mortgage is great and decides to go for it. What she doesn’t realize is that she isn’t actually saving $500 a month. The $500 represents interest she owes her lender but isn’t paying. As a result, her lender is adding this $500 per month to her $200,000 mortgage amount. So instead of paying down her mortgage, Sue is actually increasing the amount she owes her bank every month. Eventually, she would receive a notice to start paying the full $1,200 mortgage payment—as indicated in the fine print of her mortgage contract.
Many US HomeBuyers used these ‘cheaper’ mortgages as a reason to spend more on a home, unaware that when the clock ran out on their low monthly payments, they would be stuck with payments equaling up to 60% of their income.
Now that we know a little bit more about the subprime mortgage market in the US, what can we make of media reports about the collapse of that market? The collapse means that a large portion of Americans with subprime loans are defaulting on their mortgages because they can’t make their monthly mortgage payments. When a borrower defaults on her mortgage, it means that the lender takes possession of the house (or seizes it) and tries to sell it to get back any money owed. When borrowers default in large numbers, the result can be devastating for affected real estate markets.
First, there is a sudden increase in the number of homes on the market as lenders try to sell seized homes, depressing home prices in general. Second, lenders become a little more cautious and selective about lending out hundreds of thousands of dollars. Borrowers who would have qualified for a mortgage before the subprime meltdown are suddenly unable to find financing. The net effect is that there are more homes on the market and fewer buyers chasing those homes. While some might try to see a silver lining in that HomeBuyers are primed to pick-up bargains, it is of small comfort to the US as a whole; the decrease in consumer confidence that tends to accompany a large-scale real estate slide means that an overall economic downturn is on the horizon.
While recent events have proved worrisome to real estate watchers in the US, the underlying differences between American and Canadian mortgage markets have confined troubles to south of the border, leaving hot markets across Canada unaffected. Now that we are a bit clearer about why the Toronto real estate market isn’t slowing down, I’ll talk about why it’s setting a record pace in a future post.
August 21, 2007Market |