The fail

On Wednesday the Bank of Canada failed to pulled the trigger. The first in a string of interest rate increases has not occurred, despite overwhelming market belief it would take place.  It appeared the world was about to change as a result. Worse at first, better later. But for a while, the same.

Here’s the context going forward. As a result of today’s wimping out in Ottawa, there’s even more of a move likely in March.  If you didn’t take the mortgage advice from a certain pathetic blog, there is still time. Here’s why we’re at a precarious moment.

House prices are nuts. Not just once-in-a-generation ridiculous. This is more Biblical. Average families can’t afford average houses on a scale hitherto unknown. Prices nationally went up 27% last year. Inventory collapsed. Household debt hit new levels of absurdity. The biggest bank says it now takes 70% of pre-tax earnings (and a 25% down payment) to buy a house in Vancouver. In other words, nobody can.

Things are 50% more unaffordable than just five years ago when governments went nuts about a ‘housing crisis’ and brought in tough new measures. They failed. It’s worse now. And as you can see since the last federal election in September, politicians have largely given up.

This is where your central bank comes in. The crude and blunt hammer of interest rates is the last, best chance of rescuing the fading dream of home ownership. But to get to a better place, there will be rivulets of blood running in the gutters. Lots of people who do not prepare will get whacked.

Blameless, but dumb, they bought properties with huge dollops of leverage taken at teaser rates. Parroting conditions that preceded the US housing collapse of 2005-6, millions of Canadians now have variable-rate mortgages they took only for one reason – they needed to cheapest rate possible in order to get into a home.

Look at this chart. More than half of all new borrowings are VRMs.

What’s it mean?

VRMs have an interest rate tied to the bank prime, now 2.45%. Lenders have been offering variable-rate loans at deep discounts of, for example, prime minus 1%, or less than 1.5%. That’s a huge discount over the rate on a conventional mortgage, which is fixed for five years. But variable-rate loans have, gee, variable rates. Who knew? Every time the central bank raises its benchmark, the prime hikes and so does the cost of a VRM. Sometimes this is passed through in higher monthly payments. Often the payment stays the same but interest charges jump and debt repayment stalls.

The problem is that the next rate hike will be just the start. There could be four or five in 2022, and additional moves in 2023. People with VRMs must then either convert to a fixed-rate and pay a stiff penalty to do so (three monthly payments), or wait until renewal and get hit with a bomb.

Meanwhile posted mortgage rates that rise along with the CB’s tightening schedule will absolutely cool the real estate market. After an initial flurry of panicked buying by those people trying to grab low rates, there is no alternative. Fewer and fewer can afford to purchase now, even with a 1.5% variable-rate loan and 20x leverage. So how many buyers will be left when the least expensive mortgage has doubled? It is inevitable prices correct in order for the market to function – especially if Ottawa in the meantime takes aim at investors who have been scooping up 25% of available properties. And as prices start to flatline then fall, listings increase. Owners will try to get out at the best price before conditions worsen. More listings and higher rates are a recipe for lower prices.

So what happens if the value of the property you bought in 2021 with a VRM and 5% down starts to decline and your effective interest rate rips higher?

Exactly. My Bay Street buddy David Rosenberg and I don’t share a lot of views, but he was close to the mark this week in saying this: “If the Bank of Canada goes at least as far as what the rates market has priced in, you’re going to have arithmetically at least a 25 per cent plunge in residential real estate values.”

The parallels to the American real estate plop (that led to the 2008-9 credit crisis) are just too compelling: A housing boom based on cheap money and rampant speculation. Lenders offering huge leverage, partly because of government loan guarantees. Investors, usually leveraged to the hilt, helping to financialize homes. House porn everywhere in the MSM (“House gets 100 offers, sells for $669,000 over asking…”). Rampant household debt accumulation. Lenders pushing teaser interest rates destined to rise in the future. Blog comment sections teeming with people saying, ‘’Rates will never rise,” and “The government won’t allow it ‘cuz everyone’s in debt”, and “Real estate will never go down…”

What happened? US house prices, on average, fell 32%. It took ten years for them to recover. In some area codes (Phoenix, Vegas, Florida), values plunged 70%. The financial system shuddered, because America had adopted policies promoting home ownership and allowed residential real estate to become too big a piece of the GDP.

Well, we’re way beyond that. And while our banks are strong and most of their mortgage portfolios are taxpayer-backed, there’s much danger on the streets of Kelowna, Brampton, Milton, Halifax and everywhere. Risk lies on the shoulders of borrowers, those who are leveraged, with scant equity and floating mortgages, or reckless amateur investors with home equity lines of credit they used to invest in a second property.

The moment you denied is still coming. Do not squander the reprieve.

About the picture: “Our Pandemic Pitbulls pause for a pic prior to playing passionately on the playground,” writes Andrewsi. “Siblings Gibson the Grey & Brindle Bala celebrate their 2nd birthday on January 27th – tomorrow. They’ve brought our family nothing but joy. We picked up the pair for only $100. Best C-note I’ve EVER invested!”

ABCs of RESPs

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  By Guest Blogger Sinan Terzioglu
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It’s never too early to start saving for your child’s education but all too often I hear about unsuspecting new parents signing up with group RESP providers like Canadians C.S.T. Consultants and Canadian Scholarship Trust Foundation and not understanding the high enrollment fees and sales charges.  They’re outrageous and can amount to 20%+ of contributions.

Group RESPs pool funds from a number of individual accounts and parents buy units of the plan based on a contract.  Providers typically manage plans through non-profit trusts or foundations but market and administer the plans through a distributor working under a for-profit corporation linked to the foundation.  The plans are inflexible and in the early years a significant portion of the contributions does not go towards a child’s education but instead towards paying off sales charges.  Needless to say, it is best to avoid them.

For parents not working with an advisor the best way to start saving for their children’s education is to open a self-directed RESP with a bank, or discount brokerage.  As soon as a child has a social insurance number contributions can flow.  The lifetime contribution limit per beneficiary is $50,000 and the government incentivizes subscribers with the Canadian Education Savings Grant (CESG) adding 20% to the first $2,500, to a maximum of $500 per beneficiary each year.  The lifetime maximum is $7,200 and grants are paid up to the age a beneficiary is 18.

Frequently asked questions: 

1. What happens if I miss a year?  Can I catch up on education grants if I start contributing to an RESP for my child when they are 5 years old?

You may catch up on missed grants one year at a time.  So if you contribute $5,000 this year you will get $1,000 in grants – $500 for a missed year and $500 for the current year.

2. How are funds taxed?

Funds grow tax-free in an RESP and, when withdrawn to pay for post-secondary education and related costs, withdrawals are taxed in the hands of the students.  Since most have little to no income, taxes will be low.

3. Can I have multiple beneficiaries in an RESP or do I have to open a separate RESP for each of my children?

You can have multiple beneficiaries in a family RESP and education grants can be shared amongst all the children but only up to the maximum of $7,200 per child.  If a child has received the maximum you cannot share another child’s grant with them.

4. What happens to an RESP if my child decides not to purse post-secondary education? 

An RESP can stay open for up to 35 years so if your child decides to delay their decision leave the RESP as is and the funds continue to grow tax free until withdrawn.  RESPs are flexible so you have several additional options such as:

  • Naming a new beneficiary under the age of 21 and a sibling of the former beneficiary.
  • Withdrawing the funds, when contributions made to the plan are returned tax free but government grants not used for education are returned.  Up to $50,000 of earned income can be transferred to a subscriber’s RRSP or spousal RRSP so long as there is sufficient contribution room.
  • Transfer the earnings to a Registered Disability Savings Plan (RDSP) so long as the beneficiary of the RESP and RDSP are the same.  Also, the RESP must have been in existence for at least 10 years and the beneficiary must be at least 21 years old and not pursuing post-secondary education.

5. How much money can be withdrawn?  Is there an annual limit?

For the Education Assistance Portion (grants + investment growth), up to $5,000 can be withdrawn during the first 13 weeks of a qualifying program but there are no limits after that.  For the original contributions there are no limits on the withdrawals.

6. What investments can I hold in an RESP?

Any investment that is eligible for an RRSP in a RESP.  The most ideal investments are diversified exchange traded funds (ETFs) that track global equity markets and ETFs holding fixed income securities such as government bonds, corporate bonds and preferred shares.

7. Can RESP funds be used for other expenses related to education?

Costs related to school expenses like books, housing and transportation ca be covered using RESP funds.

8. Is it better to make lump sum or periodic contributions?  

The sooner and more that you are able to contribute the better.  For those fortunate enough to be able to contribute $50,000 in year one they will gain the most even though they would only receive less in the form of education grants.

9. What is the Canada Learning Bond (CLB)?

The Canada Learning Bond is money that the government adds to an RESP for children of low-income families.  All one needs to do is open an RESP to receive an initial $500 without any initial contribution from the subscriber.  Children of low income families may also receive an extra $100 each year for 15 years until their 15th birthday for a total of $2,000.

10. When are the education grants paid in a RESP?

The government pays the education grant at the end of the following month that the contribution is made.  So if you contribute to an RESP in January the contribution is reported at the end of the month and the government takes 4 weeks to process the payment.

For those unable to contribute larger lump sums the best strategy to strive for is to contribute $2,500 per year for each beneficiary. This will be the easiest 20% you’ll ever make.  If possible it is best to contribute every January so you receive the education grants as soon as possible and have them working for as long as possible.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.