Canadian Mortgage Regulator to Introduce Loan-to-Income Limits
Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), is moving ahead with implementing loan-to-income (LTI) restrictions for lenders. This decision signals a focus capping individual borrower debt levels, as part of a holistic apporach to managing financial system risk. The regulators acknowledge acknowledging concerns about stifling competition and exacerbating housing affordability issues, however while lender’s can’t compete on how much Canadians can borrow they can still compete in areas like rates, fees, digital accessibility, speed-to-approval, customer service, and advice.
The Core of the Proposal
After a nine-month consultation, OSFI confirmed its intent to implement LTI restrictions that mortgage loan amounts at 450% (x 4.5) of a borrower's income. However the regulator provided lenders with a generous exception. 25% of a lender’s mortgages don’t need to follow the new restriction. Likely, this will become a standard rule that will be waived for “high value” clients.
The loan-to-income ratio of 4.5, could have also been achieved by modifying the current stress:
effectively qualifying every borrower according to a 25-year amortization
using a 5% or higher qualifying rate, irrespective of the actual contractual amortization or rate offered by the lender.
The net effect is that the change reduces the degrees to which one can manipulate contractual rates and amortization periods to help borrowers qualify for larger amounts of debt.
This aligns with the regulators’ positions that:
“We believe that housing market imbalances are driven by both demand and supply-side factors,” the report states. “Adequate housing supply that keeps pace with demographic needs supports a stable, well-functioning mortgage market and the broader Canadian economy.”
In other words, the regulator believes that sustainable affordability will not be achieved by repeatedly changing mortgage rules to help people take on larger mortgages, but rather by providing an adequate housing supply.
Pros: Risk Management and Stability
Background
The Bank of Canada identifies and monitors areas of vulnerability in the economy and financial system. Vulnerabilities are pre-existing conditions that may interact with changes in the economy and lead to episodes of financial stress or even a financial crisis. They can amplify and further spread shocks throughout the financial system. Two vulnerabilities the Bank tracks are:
the elevated level of household indebtedness.
high house prices.
OSFI's primary mandate is the safety and soundness of the Canadian financial system. These rules prioritize stability and systemic risk containment over immediately solving housing affordability, a goal widely acknowledged to be a supply-side issue. Affordability and housing supply are the responsibility of the Canada Mortgage and Housing Corporation (CMHC), and not the banking regulator.
Benefits
Levels the Playing Field
The proposed measures partially level the playing field, primarily by standardizing the qualifying process.
The cap on loan-to-income ensures that all buyers face the same, irrespective of the lender's current competitive offering. This prevents lenders from using creative financing structures (longer contractual amortizations, lower contract rates) to artificially inflate a buyer’s qualifying capacity and their home purchase budgets.
Cap Houshold Indebtedness
The proposed LTI limit offers a balanced approach to managing systemic risk with a straightforward tool that is easy for lenders and the public to understand.
The loan-to-income cap directly addresses high household indebtedness, which the Bank of Canada and OSFI view as a significant vulnerability.
By limiting the volume of high-LTI mortgages, the regulator helps ring-fence the financial system against a widespread default scenario should house prices or interest rates shift dramatically. This prevents a concentration of risk within lenders’ books.
This isn’t a compassionate olive branch to homebuyers, nor is it a paternalistic “government knows best” policy that tells people not to take on too much debt. The regulator has implemented this rule to mitigate the risk of banks and mortgage lenders failing in the event of a significant property market correction or high borrower defaults. The goal is to ensure the government won’t be on the hook to bail out failed banks.
They are preparing for a worst-case scenario. Back in July 2016, OSFI sent out a notice to certain banks requiring them to test their resilience against a 30% drop in house prices across Canada. In particular, OSFI said these banks should stress-test a 50% plunge in Vancouver and a 40% drop in Toronto.
At the time, a benchmark Vancouver house was valued at $1.75 million, and an apartment was valued at $500,000. The benchmark Toronto house was $ 840,000, and an apartment was $ 350,000.
Today, a benchmark Vancouver house is valued at $1.95 million after falling 8% from the peak, and a Toronto house is valued at $1.2 million, down 27% from the peak. Benchmark Vancouver and Toronto apartments are $730,000 and $570,000, respectively. Vancouver and Toronto apartment prices have decreased by 8% and 26% respectively, from their 2022 peaks.
From the regulator’s perspective, these markets haven’t yet hit the worst-case scenario.
Reduce Lender Ability to Compete for Higher Risk
The policy limits lenders' ability to compete for business by helping Canadians get bigger mortgages (i.e., take on more leverage and risk).
Cons: Over-Regulation and Market Distortion
The change reduces lenders' ability to compete by offering larger mortgages, which could be achieved today by lowering the contract rate and/or extending the payback period (i.e., amortization) for the mortgage. Some lenders have products specifically designed to do this, which they use to win business from some of the larger big-brand lenders.
Small Lenders Might Struggle to Win Business
Smaller financial institutions with specialized or unique business models risk being disproportionately impacted by the LTI limit. This could stifle competition by restricting their ability to serve specific market segments, potentially leading to market consolidation among the largest banks.
Too Little Too Late
Critics argue that, while the measures are a good idea in principle, they may be "too little, too late," only becoming effective after significant household debt has already been accumulated.
Furthermore, the LTI limit still allows lenders to offer exceptions to the rule for 25% mortgage values for high-LTI loans, potentially blunting its impact.
Reduces Housing Affordability
The regulations do not address the root cause of the housing crisis, the lack of supply. By restricting borrowing capacity, these rules primarily limit demand at the margin, which can make it harder for qualified first-time buyers in high-priced markets to secure a home. The restrictions may also affect younger, high-earning professionals who typically require a high LTI early in their careers but possess strong long-term earning potential.
Pushing Risk to Provincially Regulated Channels
Credit Unions and Private Lenders are provincially regulated and not subject to OSFI’s rules. Overly restrictive measures could unintentionally push high-LTI borrowers toward credit unions and private lenders, transferring risk out of the federally regulated system to some of the smallest lenders in the mortgage ecosystem and also potentially increasing financing costs for borrowers.
Key Takeaway
The Change Reduces the Chances of a Taxpayer Bailout of the Banks
First, the regulator wouldn’t change the rules unless it believed Canadians and Canadian lenders were taking on too much risk under the existing rules.
The regulator and the Bank of Canada are concerned about high indebtedness and high home values in Vancouver and Toronto. Their worst-case, but less likely scenario, is a 50% plunge in Vancouver property values and a 40% drop in Toronto. Toronto has already dropped over 25% from the peak.
Ultimately, while the OSFI rules strengthen the regulatory environment by ensuring a consistent, conservative approach to debt qualification, they do little to directly enhance affordability, which remains dependent on housing supply.
The Change is Equitable
On the bright side, the loan-to-income rule is much easier to explain to borrowers than the stress test and debt-service ratio.
Also, it levels the playing field for home buyers. Nobody has to worry that someone else, who is willing to take on more risk, can qualify for a larger mortgage and outbid them.
