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Canada’s new mortgage rules risk pushing borrowers deep into the shadow lending market, with brokers set to line up secondary loans with private lenders as a means of circumventing tests on borrowers’ ability to repay debt.

Canadian officials have become increasingly alarmed by systemic risk from record household debt levels and a frothy housing market. In the latest bid to cool the red hot Vancouver and Toronto markets, Ottawa’s new rules require lenders to stress test borrowers’ ability to pay back loans at levels higher than current rates.

As a way around them, brokers are planning to direct more borrowers to the so-called shadow lending market where private investors, frustrated by low interest rates on savings accounts, are eager to lend at rates that can enter the double digits.

These combined loans take borrowers up to the kind of loan-to-value ratios that were common in the United States prior to the 2008 subprime mortgage crisis.

Canada’s biggest non-prime lender Home Trust is already selling a “bundled” product, twinning a conventional mortgage with a second loan by private lenders, which enables home buyers to borrow up to 85 per cent of a property’s value.

The new rules that took effect on Oct. 17 require buyers applying for an insured mortgage to show they can afford to pay it back at the Bank of Canada’s five-year fixed rate of 4.64 per cent. Canada’s biggest banks currently offer mortgages at rates about two percentage points below that.

To bypass that test, buyers can make a 20 per cent down payment that qualifies them to take out an uninsured mortgage. Brokers said many buyers will turn to unregulated private loans to enable them to make that payment.

Rising costs

“It pushes Canadians into private second mortgages, and it’s just costing more and more money for these people,” said Toronto broker Mark Cashin, who has arranged such deals in the past and expects to see more under the new rules.

Cashin said private second mortgages in Toronto typically charge between 7 and 10 per cent in interest.

“It’s not a good option but maybe it’s the only option we’ve got,” said Ron Alphonso, a private mortgage lender and mortgage agent who arranges home loans for borrowers who can’t get financing from mainstream banks.

Alphonso said he is working on two cases where he’s trying to arrange secondary lending by private investors to enable clients to obtain mortgages.

“It’s a way to get around the new rules,” he said.

Investor pools

As an alternative, he said he is looking to pool together a group of private investors to invest around $50 million offering mortgages to borrowers that don’t pass the new tests at annual rates of between 4 to 6 per cent.

Debt counselors said the rules could have the unintended consequences of allowing aggressive alternative lenders to take a bigger share of the market.

“They are going to turn to these unconventional lenders and pay higher prices and it’s not just going to be a higher price for one year, it could be a higher price for three, four, five years,” said Scott Hannah, chief executive of Canada’s Credit Counseling Society, a charity that advises people on debt.

“They want to get into the market, in some cases at any cost, and the cost is going to be a very high mortgage payment.”

Canada’s finance ministry and Home Trust did not immediately respond to requests for comment.

Originally posted in National Post