Canadians’ heavy mortgage loads are officially a key risk facing the nation’s economy, according to the Spring Financial Systems Review released by the Bank of Canada.
The central bank’s tome, which assess the downsides and main vulnerabilities posed to the country’s financial system, noted that while business balance sheets and households are “generally in good shape”, the larger mortgages taken on as a result of the pandemic's skyrocketing home prices are of increasing concern, in addition to tighter borrowing costs, steep inflation growth, and rising geopolitical tensions.
“The Bank is paying particular attention to the fact that a greater number of Canadian households are carrying high levels of mortgage debt,” states the report. “These households are more vulnerable to declines in income and rising interest rates. While the sharp increase in house prices over the past year has resulted in significant equity gains for many households, those who entered the housing market in the last year or so would be more exposed in the event of a significant price correction.”
As a result, should a “trigger event” impact the economy, the BoC adds, the effects could be significant for consumers and the real economy, even as “systemically important financial institutions remain resilient.”
The Bank notes that house prices have increased 50% on average during the pandemic, fueled partly by speculative investor demand. While that’s boosted net worth and equity for many households, it goes hand-in-hand with a higher share of highly-indebted households.
This will be especially felt when mortgage borrowers face higher rates at renewal time. The central bank has increased its rate three times since March -- including super-sized 0.5% hikes this month and last -- to bring the base cost of borrowing up to 1.5%. As a result, the consumer lenders’ Prime Rate is now 3.7%, while five-year fixed mortgages now hover in the 5% range.
According to the BoC’s calculations, a household that took out a mortgage between 2020-2021 will see a median increase of $420 -- or 30% -- in their monthly mortgage payments upon renewal. For variable-rate borrowers, that increases to $700 per month, while fixed-rate borrowers will see payments increase by $300. The difference, says the Bank, is due to variable-rate borrowers taking out generally larger mortgages during the pandemic, given their historical lows. Overall, the number of households who are highly indebted -- defined as having a debt-to-income ratio of 450% -- is expected to outpace pre-pandemic levels and hit a new record this year.
Dropping Home Prices Also Pose Risk
Households with hefty mortgages are at higher risk of a reduction in wealth and access to credit should housing markets see a considerable decline in prices, a trend that’s already starting to play out in response to the BoC’s most recent rate hikes.
The most recent April data from the Canadian Real Estate Association revealed aggregate home prices dipped 12.6% on a month-over-month basis, following the BoC's first hike. That's being even more acutely felt in localized markets, especially those that saw the greatest price run ups during the pandemic; home prices have dropped up to $80,000 on a monthly basis in May in some of the Greater Toronto Area's suburban markets, for example.
While the BoC declined to label the market’s recent softening as a “correction”, a number of other economists are starting to make the call.
Recent analysis from Desjardins foresees home prices could decrease by as much as 15% by the end of 2023 due to rising mortgage rates. As co-authors Senior Economist Hélène Bégin and Senior Director of Canadian Economics Randall Bartlett wrote in an investor note, “Looking ahead, we believe ever-higher borrowing costs are going to weigh on housing market activity as increasingly interest-sensitive households batten down the hatches for the impending storm. This is expected to lead to sustained weakness in sales activity, thereby keeping persistent downward pressure on prices.”
“While a correction in the range of 10% to 20% is likely by the end of next year in most provinces, average home prices are expected to remain above the pre-COVID level and trend. As such, the anticipated correction should bring more balance to the Canadian housing market.”
Another take from Capital Economics Senior Economist Stephen Brown is that the BoC’s rush to fight inflation and raise interest rates to neutral “suggest that it will be unfazed by the second consecutive double-digit drop in home sales in May,” and that they risk inciting a recession should they move too aggressively on monetary policy.
However, in a press conference following the release of the FSR, BoC Governor Tiff Macklem doubled down on the need for rising interest rates and that, in addition to reeling back inflation growth, they would help bring better balance to what has been an unsustainable housing market.
“The economy can handle -- indeed needs -- higher interest rates,” he stated. “Moderation in housing would be healthy.”