On June 9, the Bank of Canada (BoC) said that high home prices and the debt that comes with them are threatening Canada’s economy and is warning that buyers who purchased homes during the pandemic are vulnerable to even slightly higher mortgage rates, the Canadian Broadcasting Corporation (CBC), Canada’s state-funded media arm, reported.
“Even as the average household is in better financial shape, more Canadians have stretched to buy a house during the pandemic. And these households are more exposed to higher interest rates and the potential for housing prices to decline,” Bank of Canada Governor, Tiff Macklem, said on Thursday according to the CBC.
In Canada, an estimated two thirds of Canadians are homeowners. While half of them own their homes outright the remaining continue to service mortgages.
During the pandemic, Canadian home prices surged by around 50 percent on average, as historically low interest rates allowed buyers to shoulder more debt while keeping payments in a manageable range.
According to the BoC, inflated home prices are built on a foundation of debt and almost one in five Canadian households are now considered “highly indebted,” or in other words, their debt to income ratio is 350 percent or more.
This stands in contrast to prior to the pandemic when only one in six Canadian households were in that much debt. “Barely 20 years ago, in 1999, only one out of every 14 households had that much debt,” the CBC reported.
Royce Mendes, a Desjardins economist, told the CBC, “Those numbers mean that each rate hike will inflict more pain on the economy than it would have in the past.”
The BoC slashed its benchmark interest rate when the pandemic emerged as a means to protect the economy from uncertainty; however, as a strategy to reign in historic inflation the BoC has now begun increasing its benchmark lending rate.
The BoC increased its benchmark lending rate from 0.25 percent at the beginning of 2022 to 1.5 percent today. The Canadian housing market reacted immediately, showing signs of lower sales volumes and houses began trading at lower average selling prices.
Macklem told the CBC, “Given the unsustainable strength of housing activity, moderation in housing would be healthy. But high household debt and elevated house prices are vulnerabilities.”
BoC forecasts mortgage payments could surge by 30 percent
Trying to determine how resilient Canada’s financial system would be in the face of various shocks, the BoC analyzed what the impact of higher interest rates, and lower home prices, would look like.
Part of the analysis included looking at what mortgage payments could be when they come up for renewal in five years.
The BoC assumed that in 2025 and 2026 variable rate loans will cost 4.4 percent while fixed rate loans would be marginally higher at 4.5 percent. These rate hikes are two percentage points higher than what a borrower would be able to secure today.
“Under that scenario, the 1.4 million Canadians who got a mortgage in 2020 or 2021 would see their median monthly cost go up by $420 (US$331.00), or 30 percent upon renewal” the CBC reported.
Fixed-rate borrowers would experience an increase that is slightly less, around 24 percent while variable rate borrowers would have to shoulder a possibly intolerable increase of 44 percent.
“If those in highly indebted households lose their jobs, they would likely need to reduce their spending sharply to continue servicing their mortgage,” Macklem told the CBC, adding that, “This is not what we expect to happen … But it is a vulnerability to watch closely and manage carefully.”