The typical Canadian mortgage matures in 5 years or less. Why can't Canadians get (say) 30 year mortgages? I used to think that the answer was "inflation", or "inflation uncertainty". Now I don't. Now I think the answer is "Section 10 of the Canada Interest Act". Which we should abolish.
Why can Americans get 30 year mortgages? I used to think the answer was "some sort of implicit subsidy by Fanny and Freddy". Now I'm not so sure.
This post is mostly about Canada. But it has implications for Americans. On reading US comments and responses to my previous post, I get the impression that there's a general assumption that the US 30 year mortgage only exists because of government support. I'm not sure that's right. Or rather, it may depend on what sort of 30 year mortgage we are talking about.
We really need to distinguish "closed" from "open" mortgages.
A 5-year "closed" mortgage means the interest rate is fixed for 5 years. That's the typical Canadian mortgage. If you want to pay it off earlier, you have to compensate the lender by paying the difference between the old and new interest rates over the remaining term of the mortgage. That means you never have any incentive to renew a mortgage if interest rates fall.
A 30 year "open" mortgage means you can pay it off any time you like. So if interest rates fall, you have an incentive to renegotiate the mortgage and take advantage of the new interest rates. That means the interest rate you pay cannot rise, but can and probably will fall. That's the typical American mortgage.
The 1880 Section 10 of the Canada Interest Act puts a maximum penalty of 3-months' interest on repaying any loan over 5 years after 5 years have passed. That's a small penalty, and it would take only a small fall in interest rates to make it worthwhile for a borrower to exercise his option to renegotiate created by Section 10. In effect, closed mortgages of longer than 5 years are effectively banned in Canada. All mortgages longer than 5 years are effectively open mortgages, whatever the contract says.
There is a market in open mortgages in Canada, but nearly all are for very short terms, like 6 months or 1 year.
In Canada: open mortgages for longer than 1 year fail the test of the market; and the market for closed mortgages for longer than 5 years is effectively banned.
What are the implications for Americans? The typical American 30 year open mortgage would probably fail the test of the market. But a 30 year closed mortgage might very well pass the test of the market.
Why do I think a 30 year fixed rate closed mortgage might meet the test of the market, if it weren't banned in Canada by Section 10? Because it meets the desires of both borrowers and lenders, or at least some borrowers and lenders.
Let's start with the borrowers. We are born with a long position in human capital, and a short position in housing. We will need somewhere to live for the rest of our lives. Buying a house is a way to cover your short position in housing, and protect yourself against the risk that future rents may rise. If our only asset is human capital, the stream of our future wage income, but we can't sell our human capital in the futures market, the next best thing may be to finance the house with a 30 year mortgage with a fixed interest rate. (The ideal mortgage would be one where the monthly payments were positively correlated with our wage income, but that vehicle might not exist). A variable rate mortgage might be better, if the level of interest rates were positively correlated with the level of our wages (as opposed to the rate of change of our wages, i.e. wage inflation), but they might not be. And the market shows that more Canadians chose a 5 year fixed than a variable rate mortgage. And the open mortgage is a weird hybrid, that is fixed when interest rates rise, but variable when interest rates fall. Except for people planning to sell their house in the next year, who want to minimise the hassle of dealing with a closed mortgage, I can't think why it would meet the needs of borrowers. And it fails the test of the market, at terms longer than 1 year.
Now the lenders. People about to retire at 65 need a safe investment for the next 30 years or so. Or the pension plans that offer them a life annuity need a safe investment. Except for the fact that mortgages are typically not indexed for inflation, a 30 year fixed rate closed mortgage looks close to ideal. And if the Bank of Canada sticks to its 2% inflation target, this concern matters less than it did in the past. If all fluctuations in nominal interest rates are due to fluctuations in real interest rates, and not to fluctuations in expected inflation, as they should be under credible inflation targeting, then variable rate mortgages will not provide a good inflation hedge, and will create risk of real interest rates fluctuating.
If a good seems to meet the needs of potential buyers, and sellers, but doesn't exist in the market, the presumption should be that the fact that Section 10 of the Canada Interest Act bans the good is the reason why it does not exist.
But what if I want to move house in the next 30 years? No problem, and it isn't a problem in Canada already, if you want to move house in Canada before your 5 year mortgage is up. Mortgages can be transportable (you take them with you to the new house), or assumable (the new buyer, OAC, takes over your mortgage). Really, mortgages are just like fridges and stoves in that regard. You don't get a 10 year stove because you think you will move in 10 years. And if you want to sell and rent? Can't you just use the proceeds to buy a bond, and leave the bond as collateral for your mortgage? And if you suddenly win the lottery, and want to pay off your mortgage? You can always pay the interest rate differential, plus any transactions costs.
Canada Deposit Insurance Corporation insures GICs of 5 years or less, but not longer than 5 years. That might also be part of the explanation why Canadian mortgages are 5 years or less. Banks borrow at terms up to 5 years, so want to lend at terms up to 5 years. Maybe.
Eric Lascelles of TD has written an excellent primer (pdf) on the Canadian mortgage market (with some comparisons to the US).
I thank all the commenters on my previous post for excellent comments that helped me write this post. Blogging is a team-effort. Comments are integral to blogging. That's how we can cut across disciplines and areas of expertise. And we need to. That's worthy of a post sometime.