Announcements from the Bank of Canada are rarely something to get excited about, but you may want to keep your eye on news of rising interest rates.
A single increase in the overnight rate by 0.25% is not going to radically change the economy and household finances, but it would be more than just symbolically significant. Many Canadians have become accustomed to cheap debt—mortgage rates, for example, have been falling since the 1980s—and the next few years could see a reversal of that trend.
It’s important to acknowledge that rates could steadily climb over the next several years, and that sooner than later the economy will be heading towards a higher rate environment.
Here’s how that will play out in a few key ways.
Growth in household debt will slow
One number has probably generated more economic headlines and hysteria about rising interest rates than any other: the household debt-to-income ratio. As of the fourth quarter of 2019, Canadians owed $1.76 for every dollar of disposable income earned. (A decade ago, it was $1.56 for every dollar earned.) One recent study found that Canadian households and companies are piling up debt faster than any other developed nation in the world, adding $1 trillion since 2011. A dubious honour, to be sure.
The increase has been driven by historically low interest rates. Naturally, an uptick in the cost of borrowing should dissuade Canadians from taking on debt at such a fast pace. There are already signs the debt-to-income ratio has peaked (it ever-so-slightly decreased in the last quarter, for example) and a rate hike could cause it to slow further or flatline.
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Anything to prevent Canadians from becoming even more indebted should be a good thing. But debt-fuelled spending has helped boost the economy since the financial crisis. If households cut back, won’t the economy suffer? Not necessarily. “The only reason the Bank of Canada would even entertain raising interest rates at this point is because the economy is strong enough to sustain it,” says Beata Caranci, chief economist at TD Bank Financial Group. GDP is growing at an annualized rate of 1.64%, and other sectors are starting to pick up the slack from the country’s juggernaut of a real estate industry.
Canadians will pay more to service debt with rising interest rates
Households have been able to take on so much debt because the monthly cost to pay it down has been fairly low and stable. As a result, the debt service ratio (which measures the costs to pay down loans compared to disposable income) has bounced around 14% for the past decade.
That will change if the Bank of Canada raises its benchmark rate, driving up the cost of loans of all kinds. The Parliamentary Budget Office recently estimated the debt service ratio will increase to more than 16% over the next few years, warning that the “financial vulnerability of the average Canadian household would rise to levels beyond historical experience.” It’s an open question how some Canadians will cope with higher payments. “Some households might not be able to afford an increase,” Donald says. “And this where we can see defaults, first on auto loans and then on housing.”
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If Canadians are paying more to service debt, they’ll also have less money to spend, which could weigh on the economy. That’s part of the reason why economists anticipate the Bank of Canada will tighten gradually and allow households time to adjust.
Mortgage rates will go up
Most Canadians opt for fixed mortgages so these households with existing mortgages won’t be affected immediately. Even those refinancing a fixed mortgage in the next little while will likely still score a lower rate than five years ago.
But those with variable mortgages, which move with the Bank of Canada rate, could see an immediate (though still modest) effect to rising interest rates. According to a survey conducted by Mortgage Professionals Canada in 2016, about 25 per cent of buyers chose a variable or adjustable rate mortgage. New buyers, regardless of which option they choose, can expect to pay slightly more on a monthly basis for a mortgage than in the past, which means…
The housing market could cool
Falling rates have been an important driver of the residential real estate market, since buyers can take on bigger mortgages. Higher carrying costs reverse that trend. According to Donald, the markets that could be most affected are not necessarily Toronto or Vancouver, which are popular cities for foreign buyers and speculators who aren’t as fazed by rising interest rates. Poloz said that even a five per cent rate hike wouldn’t dissuade speculators.
Instead, first-time buyers play a much bigger role in the rest of Canada, and they’re more sensitive to interest rates. Markets in these regions are already flat or cooling as the federal government and regulators have tightened mortgage rules numerous times over the past few years. Compare just about any other city to Toronto and Vancouver, for example. The Office of the Superintendent of Financial Institutions proposed even more tightening, creating another headwind.
But the Greater Toronto Area isn’t totally immune. Real estate activity slowed dramatically after the provincial government introduced a foreign buyer tax and other measures a couple years ago to balance the market. Sales plunged 37.3% in shortly after, while new listings rose by 16 per cent. The question now is whether Toronto will bounce back like Vancouver did just a few months after the imposition of a non-resident buyer tax.
Caranci at TD is wagering it won’t. The Vancouver market benefited from falling rates, while Ontario’s policy changes coincide with rate hikes. “We have flat sales all the way out until next year,” she says. “We do think the combination of policy changes and a change in the mortgage rate environment will prevent that rebound.”
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