What Is Default Insurance?
Almost every other day you hear something about default insured mortgages. This will provide you with everything that you need to know about default insurance, and what it means to you during the home buying process.
Default insurance has been around since 1954 when it was introduced by the Canada Mortgage and Housing Corporation (CMHC). At this time a 25% minimum down payment required. This is the same concept behind default insurance today, although most of the rules and guidelines have been updated for today’s real estate markets. In 1992, CMHC launched a pilot project that allowed for consumers to make down payments as low as 5%, and by 1999, the National Housing Act and Canada Mortgage and Housing Corporation Act were modified to make this policy permanent.
The government requires anyone who makes less than a 20% down payment to have default insurance on their mortgage – the most common is CMHC (Canada Mortgage and Housing Corporation) Insurance. This insurance is protection for your lender in the event that you fail to make your obligated mortgage payments and is offered so that financial institutions aren’t accepting as much risk when they fund high-ratio mortgages (when you have less than 80% equity in your home). This allows for mortgage rates to stay lower because they are not as risky as they once were. Having said that, the premiums for default insurance fall on you as the home purchaser to pay. Because this premium is calculated off your total mortgage amount, you are able to include default insurance on your mortgage instead of having to pay a lump sum, which would ultimately take away from your down payment. Here’s an example; If you get an accepted offer for $500,000 and put down 5% ($25,000), the CMHC premium is 4% of your mortgage amount. $500,000-$25,000 down payment = $475,000 * 4% = $19,000 CMHC premium. This can be added to your mortgage amount meaning that your actual mortgage in the end would be $494,000.
Default Insured Mortgage Considerations
Having CMHC default insurance creates uniform lending policies for anyone that has CMHC insurance. Without default insurance different financial institutions can have different requirements in terms of acceptable debt limits and longer amortization terms. When you have default insurance, you must follow the insurance providers funding requirements which include lower debt servicing ratios, minimum credit scores, and that the funds for your down payment are not borrowed (Can’t use a line of credit for down payment for example). Here is what CMHC looks for in all of these categories:
Gross Debt Service Ratio (GDSR)
This is any monthly payment obligations directly related to your home purchase. This includes the mortgage principle and interest payments, utilities (which most lenders calculate at $100/month), monthly property taxes on the home you are purchasing, and if there are any strata fees (these are calculated at 50%). This is a percentage based calculation that says that your GDSR must be 35% or lower of your AFTER TAX income.
Total Debt Service Ratio (TDSR)
This is any other monthly debt obligations that you may have such as credit cards, car loans, student loans. This also includes everything in your GDSR so there may be instances where the home expenses are under 35%, but your TDSR is over the allowable amount of 42% because of other debts. Both these numbers must be met in order to get approved for a mortgage.
CMHC requires a credit score of at least 680. I use Credit Karma to get weekly reports on my credit score for free.
Mortgage Stress Test
The Canadian government have brought in the stress test as a form of consumer protection for buyers. While this ensures that Canadians can still afford their mortgage if interest rates were to increase, this adds an extra level of difficulty to getting a mortgage. The stress test currently in place means that when you apply for a mortgage, you are qualifying on a rate that can be double the amount of interest you are actually paying on your 5-year mortgage term. The current qualifying rate is 5.25%, or your mortgage interest rate plus 2%, whichever is greater. With historically low interest rates from the Bank of Canada, most mortgage stress tests are at the 5.25% rate. Using the same $500,000, you would need to be able to afford monthly mortgage payments of approximately $2,980 even if your mortgage rate was 3% and your payments would be approximately $2,367. This means that you would need to be able to qualify for almost $600 more than what you are actually buying. The benefit to this is that you can feel confident that if rates were to increase drastically you could still afford your mortgage payments and be able to keep your home.
These different considerations make it very difficult for online calculators to show the entire picture of what you can afford. Because of this, it’s important to work with your financial institution, or a mortgage broker to make sure that you have a clear outline of what is possible. The pre-approval process will also help you to be prepared to write competitive offers because you will know exactly what your maximum offer could be. In the current market, we are seeing that homes are selling for an average of 3.74% over the last 12 months. This means that $500,000 listing is selling for closer to $520,000, but this number has been slowly increasing month over month. This current seller’s market can be attributed to the overwhelming demand and very limited supply. We are hoping that an increase in inventory will help to decrease the competitiveness of the market and bring sale prices closer to listing prices. Our experience in the Nanaimo real estate market gives us the ability to forecast potential market shifts and build strategies for our clients to expand their home search and find properties that fit their criteria while also making sure that they aren’t paying an inflated price for their home. This helps with making your investment because you will see a smaller decrease of the equity in your home if the market shifts and home price decreases, and you will also realize appreciation faster if market prices continue to increase.