Canadians have been bracing for rising borrowing costs for some time; as the economy has recovered from its initial pandemic-induced shock, and the government has wound down its stimulus, mortgage holders have gotten used to the idea that interest rates would rise as of this April.

However, that timeline just got bumped up considerably, with some policy watchers calling for Canada’s central bank to return to a rate-tightening cycle as early as… tomorrow.

High Inflation to Thank for Moved-Up Timeline

While the Bank of Canada is largely looked upon as the trend-setter for the Prime rate -- and by extension, consumers’ cost of borrowing -- its main mandate, after all, is to control inflation. In non-pandemic times, they maintain a 2% target range, hiking or slashing rates in response to its performance in regards to this benchmark.

However, that target seems downright quaint amid the fiscal upheaval caused by COVID; with an economy buoyed by hundreds of billions in federal stimulus (a total of $512.6 billion has been spent on pandemic relief and stimulus efforts according to the federal budget, which doesn’t include additional spend by the provinces), inflation hit 4.8% this month -- a high not seen since the 90s. As anyone stung by a pricier grocery bill can attest, higher purchase prices are now being felt in every corner of the economy.

Combined with strong national labour numbers in 2021, that’s ramped up pressure on the BoC to put its levers to work and scale back both debt growth and consumer spending in order to get the cost of living back under control. 

As a result, rather than a steady pace of rate hikes to commence in the “later quarters of 2022” and stretch into 2023, the market is now pricing in an aggressive six to seven increases, all to occur within this calendar year. This will bring the Overnight Lending Rate -- the base used by consumer lenders to set their variable mortgage and home equity line of credit rates -- to a range of 1.75% - 2%, from the current record low of 0.25%. It will be the first rate tightening since 2018, and an eventual return to pre-pandemic borrowing conditions.

Hiking "Too Quickly" Could Tip Oversized Mortgages

Despite mounting expectations of an immediate hike, though, the timing and pace of this tougher monetary policy aren’t confirmed, and the banks remain split on just how this will play out. For example, Scotiabank and National Bank have taken the most hawkish stance of the Big Six, calling for both an increase tomorrow and a minimum of at least six hikes to come, while the Bank of Montreal has said conditions are still too close to call.

That’s because the potential volatility of the Bank making a too-aggressive move cannot be understated. While there’s undeniable urgency in their need to hike, the road forward will require a soft touch, with just the right amount of pressure at the right time, as more Canadians than ever find themselves holding market-facing debt and will be hyper-sensitive to any upward movement.

For this, we can thank the unprecedented run up in real estate prices that have occurred in housing markets, big and small, across Canada, and the oversized mortgages that came with it: the national average home price rose 18% in December from 2020, while 2021 sales reached an all time high, with the total 2020 record smashed by November. 

Added to the mix is that more of those mortgage holders chose a variable rate than ever before, with the banking regulator reporting they made up more than half of all new home loans issued between July and November last year, accounting for $378 billion. That’s a lot of market-exposed debt.

Hiking too quickly, and at too aggressive a pace will indeed usher in payment shock for those with newly-minted mortgages taken out over the last two years, with repercussions for both the housing market, which is a major contributor to GDP, and by extension, the economy as a whole should spending slow down. And it doesn’t help that borrowers have become used to ultra-cheap borrowing costs; according to rate comparison sites, the lowest five-year variable rate available today is 0.90%, representing a 1.55% discount from the current Prime rate of 2.45%.

Let’s take a look at how a rate increase could feasibly impact a borrower in the months to come.

Say borrower A has purchased a detached house in the GTA at the average price of $1,598,735, as per the Toronto Regional Real Estate Board’s December report. Let’s also assume they’ve made a 20% down payment, taken out a 30-year amortization, and have qualified for that 0.90% five-year variable rate; they’ll be looking at a monthly payment of $4,054. Now, let’s say the BoC hikes by 0.25% to 0.5% -- all other factors staying equal (and assuming the lender doesn’t reduce the discount from Prime), they’ll then be looking at a rate of 1.15%, which translates to a monthly payment of $4,201: $147 more per month. Keep in mind this is a broad example -- just how much lenders may or may not pass on rate hikes or cuts is within their discretion -- but it highlights the potential for how much more a borrower can expect to pay.

Now, let’s say the BoC does indeed hike rates a total of six times to bring the OLR to 1.75% by the end of this year. Suddenly, that mortgage holder is looking at a rate of 2.65%, and a monthly payment of $5,144. That’s $1,090 more per month -- depending on the mortgage product, rate mortgage holders may then have less going toward their principal repayment rather than swallow a higher monthly expenditure, but it'll still be a tough pill for many household budgets, and result in tens of thousands more in interest payments over time.

The good news, however, is that this is unlikely to lead to mortgage defaults en-masse; unlike the carnage witnessed in the US during the subprime mortgage crisis of the mid-aughts, buyers over the last two years have been subjected to a mortgage stress test, which has generally required them to qualify at a rate of 5.25% or 2% above their contract rate -- whichever is higher. 

Variable-Rate Mortgage Popularity Isn’t Going Anywhere

And the pain isn’t just reserved for those with floating-rate debt; while fixed-rate borrowers may be able to ride out much of today’s short-term volatility, the stage is set for higher borrowing costs across the board. Long-term government bond yields -- namely five-year instruments -- have risen steadily over the past year, up 1.2% in 12 months and increasing 38 basis points alone within the last 30 days. That’s giving lenders room to increase their rates, which will continue to fuel the appetite for variable options, as today’s lowest fixed-rate offerings are sitting in the 2.5% range, a spread of more than 1.5%.

Will Rate Hikes Lead to Lower Home Prices?

The golden question, of course, is whether rate hikes will lead to lower home prices. In not-so-great news for today’s prospective home buyers, the result is unlikely to materially move the needle in terms of affordability.

While rock-bottom borrowing costs certainly carry a good chunk of the blame for skyrocketing home prices over the course of the pandemic -- compounded by buyer urgency to upgrade and the ability to move away from city centres -- today’s lack of supply is just too steep to allow any considerable decrease in price.

The latest numbers out of the Canadian Real Estate Association reveal there were just 68,252 homes for sale nationwide in November -- the tightest conditions ever recorded, while sales activity remained 30% above the 10-year average. The national body released a revised forecast -- which accounts for anticipated BoC hikes -- in late 2021 to predict home prices to rise a total of 21.2% this year, with a more moderate 7.6% pace of growth in 2023.

So hang on -- existing and new mortgage borrowers alike -- 2022 looks to be a bumpy ride, indeed.