In an effort to stop a U.S.-style mortgage meltdown in Canada, less than a year after introducing the government-guaranteed 40-year mortgage, the Department of Finance is tightening the rules that apply to them.

Effective Oct. 15, the maximum mortgage amortization period for new mortgages will be reduced from 40 years to 35 years. All mortgages must have at least a five per cent down payment. Homebuyers must have a minimum credit score of 620 and a maximum of 45 per cent total debt service ratio (the amount of gross income that is spent on servicing debt and housing-related expenses such as heat or condo fees).

"[It's a] responsible and measured approach … to reduce the risk of a U.S.-style housing bubble developing in Canada," the Department of Finance said in a news release.

The government said the measures will apply to new government-backed, insured mortgages.

"Canadians who already hold mortgages will not be affected," the release said.

Banks will continue to process applications from clients who have applied for a 40-year amortization period prior to Oct. 15.

ING pulled the plug in July

In July, ING Direct Canada became the first domestic lender to officially pull the plug on the controversial 40-year mortgage. Even though only 10 per cent of its mortgage customers hold the 40-year mortgage, CEO Peter Aceto said, "It is really not in the best interest of Canadians."

Mortgage insurance protects lenders when a borrower defaults by making up any shortfall needed to repay the loan if the sale of the property doesn't cover the debt.

Federally regulated lenders must have mortgage insurance on loans where the buyer's down payment is less than 20 per cent of the price.

The Canada Mortgage and Housing Corp. (CMHC), a Crown corporation, as well as private insurers provide mortgage insurance.

The government of Canada backs the CMHC and also private mortgage insurers, so they can compete with the CMHC.

Just over a year ago, Parliament passed a bill changing mortgage insurance by allowing a 40-year amortization period, thereby making the process of buying a home that much easier.

Longer amortization periods are popular

The Canadian Association of Accredited Mortgage Professionals estimates that 37 per cent of all new Canadian mortgages taken from the one-year period ending in the fall of 2007 were longer than the standard 25-year amortization period.

While longer amortization periods can facilitate lower monthly payments, they are widely criticized for burdening homeowners with substantially higher total costs.

According to a TD bank representative, about 60 per cent of first-time home buyers were opting for a 40-year mortgage, which indicates that they are having a hard time affording the house and need to stretch the payments out in order to make the purchase.