On the surface, it makes no sense at all.
One borrower goes to get a mortgage, barely scraping together the minimum required down payment of 5%. Meanwhile, somebody else works their tail off and manages to save up enough to put 30% down. Not only are these two borrowers likely paying the same rate, but sometimes the borrower with 5% down will actually be paying a lower rate!
Let’s take a closer look at exactly why this happens.
As we all know, the Canadian Mortgage and Housing Corporation (CMHC) has one huge mandate. For a fee of anywhere from 3% to 5% of the value of a borrower’s mortgage, it will insure the lender against default. For mortgages with less than a 20% down payment, CMHC insurance is actually required. There’s no getting around it.
From a lender’s perspective, a CMHC insured mortgage is about as close as it gets to free money. Sure, there’s a cost associated with underwriting a mortgage to begin with, but those costs aren’t so bad when spread out over thousands of different mortgages. The biggest risk for the lender is borrowing the money to then lend out and not get paid back. But since the principal is guaranteed by CMHC, it’s more of an opportunity cost rather than a pure financial cost. The principal will come back, no matter what happens.
That's why lenders want to do CMHC insured loans. The potential for loss is very small, while the potential for gains is huge. Not only is there the potential to collect interest, but there’s also the possibility of collecting additional fees for things like late payments and mortgage termination fees.
A borrower with 30% down is also a pretty good deal for the bank. The borrower has shown a history of being smart with money and already has plenty of equity in place in case something goes wrong. From the lender’s perspective, this is a pretty good mortgage, and this borrower will likely have lenders fighting for their business.
But there’s still a small chance something could go wrong.
What if the borrower overpays for the property? What if the borrower gets hit by a bus tomorrow and doesn’t have disability insurance? Or what if the housing market in the borrower’s city falls 20% because the town’s main employer shuts down? These are all risks a lender thinks about.
Lenders play a numbers game. They know that if they lend to 100 people in a normal economic environment, approximately 90 will pay faithfully and not be a problem. Something like 6 or 7 will have payments bounce every now and again but not be a big deal. That leaves just 2 or 3 out of every hundred who will end up being chronically behind.
In the latter situation, the bank really only has one option -- foreclosure.
When a loan is backed by CMHC, the crown corporation covers all these costs if a lender loses money on the deal. Say a borrower with 5% down doesn’t pay a nickel on their mortgage, and it eventually costs the lender 10% of the value of the house in legal fees, Realtor fees to sell it, and so on. The worst case scenario for the lender is break-even.
Meanwhile, the borrower with the 30% down payment does the same thing, but in the meantime house prices have declined 15%. Suddenly, the lender only has a 15% cushion in a declining real estate environment. The bank should be okay, but there’s always the risk that it was a bad deal to begin with and it could turn out that the bank loses money.
Thus, as weird as it sounds, some lenders will charge borrowers with less than 20% down a lower interest rate. These lenders want CMHC insured business to the point of actively encouraging folks with a higher down payment to go elsewhere. This will be especially prevalent in an environment where lenders are nervous about real estate going down.
Fortunately for those borrowers, there are plenty of lenders who will treat them the same as a CMHC insured loan. You can certainly make the argument that someone with a big down payment should be treated better, but that’s just not going to happen in Canada. Not with CMHC still around.