Impending rate hikes are anticipated to be a turning point for Canada's overheated housing market, as higher debt costs will whittle into buyers' already strapped budgets, throwing cold water on demand. However, there may be another development for borrowers to contend with -- a higher threshold for the mortgage stress test.
Robert Hogue, Senior Economist at RBC Economics, outlined his forecast for tougher borrowing criteria in a research note titled The Fever Breaks: Canada's Housing Market Will Cool But Stay Strong in 2022. Like other analysts, he anticipates the Bank of Canada will commence its rate hiking cycle this spring for a total of six increases, bringing its Overnight Lending Rate -- which is in turn used by consumer lenders to set their Prime-rate linked product pricing -- to 1.75% within an 18-month time frame.
"This increase on its own will have a significant cooling effect on demand," he writes. "Exceptionally low interest rates have been a powerful tonic for homebuyers' appetites throughout the pandemic."
Read: Could Rate Hikes Lead to a 20% Drop in Home Prices?
However, he tells STOREYS, it "should be on everyone's radar" that as both fixed and variable rates start to rise, so too will the average five-year rate -- the benchmark used by policymakers to set the floor of the mortgage stress test. While the Office of the Superintendent of Financial Institutions (OSFI), Canada's banking regulator, last reviewed the criteria for the stress test this past December, Hogue says there's nothing stopping it from making another tweak by this summer, should it see fit.
“If the situation warrants it, and OSFI sees some potential concern with federally regulated [financial institutions], there’s nothing stopping it from moving it in June or July," he says. "That pressure will build and it won’t take that much, really, to see it go up.”
A More "Permanent" Impact on the Market
Currently, the floor for the stress test is 5.25%; new mortgage borrowers (as well as those switching lenders upon renewal or refinancing) must prove they can carry their mortgage payments at this inflated rate (or their contract rate plus 2% -- whichever is higher) despite existing mortgage rates being priced 2 -3% lower. This benchmark has fluctuated several times since the stress tests' initial implementation in January 2018.
While the impact of previous stress test increases have been temporary at best, Hogue thinks this one will have a more "permanent" impact, given the double whammy of a "material" hiking cycle.
“The broader context is really key to understand why those events in the past have had only a kind of temporary effect on the market in the context of rising interest rates. And rising interest rates -- it’s going to be a material rise," he says. "We’re not talking here a quarter of a percent or a half percent and then the Bank is done; we’re talking a 150 basis point -- and there’s an open debate about whether a 150 basis points will be enough -- increase."
Hogue adds that while initial expectations are for the BoC to settle at 1.75%, a "neutral rate" could be in a range of upwards of 2.75%, leaving the door open for additional upward movement.
"Our current call is that it will get to the lower end of that range, but there’s a full percentage point range there, so it could potentially go higher. There, the message too is that, where interest rates are going to rise materially, it’s going to have a cooling effect on its own. On top of that, if you add the Mortgage Qualifying Rate being brought up because of it as well, then you’ve got overall context where conditions would be enough to cool the market on a more permanent basis, assuming interest rates won’t start to go down again because of an economic hiccup. I think maybe this time around it won’t be as transitory an impact on the market as it has in the past.”
