As Canada’s housing market shows tentative signs of homebuyers’ fatigue, some economists are looking ahead at another factor that’s widely expected to put a damper on the real estate frenzy: rising interest rates.
With economic activity revving up again amid soaring vaccination rates and signs of inflation, several analysts believe the Bank of Canada will start raising its trend-setting interest rate sometime in the second half of 2022.
The question is how rising borrowing costs might affect the housing market, which has grown to account for an outsized share of the country’s $2.4-trillion economy.
“That’s the number one issue facing the Canadian economy: the increased sensitivity to higher interest rates,” says Benjamin Tal, deputy chief economist at CIBC.
With many Canadians shouldering large mortgages, even a small increase in interest rates would have a significant impact on household balance sheets, he warns. An increase of just 1.5 percentage points in interest rates could double the monthly mortgage payment for some homeowners, he says.
The Bank of Canada has left its key interest rate at an historic low of 0.25 per cent since March 2020, when the central bank quickly slashed borrowing costs to soften the impact of the economic crisis linked to the COVID-19 pandemic.
Higher interest rates are widely expected to provide a welcome breather from breakneck home price growth, Tal says.
“Even a small increase in interest rates would be sufficient to slow down the market — and that would be a very good thing,” he says.
But too much of a good thing could expose heightened vulnerabilities in the Canadian economy, Tal and other economists say.
“If interest costs were to go up one to two percentage points, because of the level of debt, households could be put in a position where they’re devoting a significant share of their income to making their mortgage payments,” says Diana Petramala, senior economist at Ryerson University’s Centre for Urban Research and Land Development.
Full impact of higher rates may take years to emerge
Canadian households have accumulated $1.96 trillion in debt held through mortgages and home equity lines of credit (HELOCs), with the pace of mortgage borrowing registering a record month-over-month increase in April, according to data from Statistics Canada.
So far, however, rock-bottom interest rates and higher incomes are helping Canadians manage their debt. Even as mortgage debt soared, overall debt loads as a share of household disposable incomes are lower than in pre-pandemic times.
As of the first three months of 2021, Canadians owed $1.72 in credit market debt for every dollar of disposable income. That compares with $1.81 dollars in debt for every dollar of disposable income at the end of 2019.
And as Canadians piled on mortgage debt, they have also been paying off more expensive kinds of debt. Canadian households’ collective credit card debt, for example, dropped from nearly $90 billion in December 2019 to $74 billion in April 2021, Statistics Canada data shows.
But as borrowing costs rise, debt-to-income ratios will likely climb as well, Petramala says. And higher interest rates may not only force homeowners to use more of their income on mortgage payments, they will also make it harder to pay off mortgage debt, with a larger share of payments going toward interest charges instead of the principal, Petramala notes.
One potential risk, says Tal, is that rising inflation will force the Bank of Canada to accelerate the pace of interest rate increases.
Consumer prices in Canada rose 3.4 per cent year-over-year in April, above the central bank’s inflation target of two per cent.
The latest inflation readings seem high in part because they are a comparison with the spring of 2020, which saw a steep decline in prices. A number of supply shortages and logistical logjams tied to the pandemic have also resulted in price spikes for materials like lumber, goods like furniture, and parts like the microchips used in many consumer electronics as well as cars and trucks.
While many of the factors pushing up prices are temporary, it’s unclear how long the inflationary pressures will last, Tal says.
“To the extent that inflation starts rising and the Bank of Canada is behind the curve and not dealing with it quickly enough, the speed at which interest rates would have to rise might go up,” he says. “And that’s something that can have a significant negative impact on housing.”
Rising interest rates would have a short-term impact on prospective homebuyers, who would see their ability to borrow reduced. This would likely cool off housing demand, Petramala says.
Movements in the Bank of Canada’s key interest rate have an immediate impact on variable-interest loans and credit products like variable-rate mortgages and home-equity lines of credit.
But changes in the central bank’s interest rate can also affect the interest on fixed-rate mortgages, especially if there’s a widespread expectation that the change to be long-lasting.
The full effect of climbing interest rates on the housing sector may not become apparent for years, as many homeowners have fixed-rate mortgages, she adds.
As of the end of 2020, 73 per cent of outstanding mortgages in Canada had a fixed rate, according to Mortgage Professionals Canada.
Given the popularity of fixed mortgage rates with a five-year term, many Canadians who bought a home during the pandemic at record low mortgage rates may not feel the effect of higher rates until renewal four to five years from now, Petramala says.
“We won’t really know the impact of the higher interest rates on household finances for up to five years,” she says.
As the housing sector grew, much of the rest of the economy didn't
Since home prices started heating up last summer, the housing sector has been a key propeller for the economy at a time when few other sectors were growing, apart from government spending.
Now, the concern is whether Canada’s economy can fire up other engines of growth if the residential real estate market cools off.
While investment in residential real estate ballooned during the pandemic, the level of private capital invested anywhere else declined, says Jeremy Kronick, associate director of research at the C.D. Howe Institute.
Recent data from Statistics Canada show that, for the first time on record, investment in the housing market is now greater than 50 per cent of all investment in the economy, Kronick adds.
That is cause for concern, he says.
“The housing market is obviously valuable and employs a lot of people — and we all need roofs over our heads,” he says. “But we also need … a successful economy and businesses that are thriving and hiring, especially coming out of the pandemic.”
The housing market — including residential construction, home renovations, homeownership transfer costs and spending on furniture, as well as home maintenance and repairs — now makes up nearly 28 per cent of Canada’s GDP, Petramala says quoting numbers from Statistics Canada.
That’s significantly higher than the 22-23 per cent slice of the economy housing has accounted for from 1987 until just before the start of the COVID-19 health emergebcy, she notes.
In part, this reflects the fact that, while housing boomed during the pandemic, the rest of the economy took “a really big hit,” she says.
But Kronick also sees evidence that investment in residential real estate is crowding out other types of business investments.
“If a bank got a new dollar … do they prefer lending that money out into the housing market or lending it out to business?” he asks. Before the pandemic, the answer tended to be that half would go to mortgage borrowers and half to businesses. Now, he says, “all of it is to mortgage(s).”
This reflects, in part, built-in incentives that predate the pandemic. For example, mortgage default insurance, which is largely government-backed and mandatory in Canada for mortgages with a down payment of less than 20 per cent, means insured mortgages are, essentially, a “risk-free loan for a bank,” he says.
But with the pandemic housing boom, residential real estate has been siphoning off even more investment dollars, Kronick says.
However, Canada needs to invest in businesses that can fuel the kind of growth that can lead to greater productivity, a key driver of rising living standards, he says.
The housing sector, as important as it is for the economy and the labour market, is not “a typically overly productivity-enhancing sector,” he says.
One of the conundrums facing Canada as it emerges from COVID-19 is whether rising interest rates can inhibit home price growth without also holding back the recovery in the rest of the economy.
Rising interest rates — particularly if they move faster than interest rates in the U.S. — could push the value of Canadian dollar higher, Tal notes.
That would be bad news, he says.
“The last thing we need is a stronger Canadian dollar, which is negative for exports.”