The low-interest-rate loans that are helping propel one of the world’s frothiest property markets could also be what causes it to burst. Canada’s housing market has soared to record heights for over ten consecutive years. Tight inventory, particularly in Toronto and Vancouver, has made property price appreciation and bidding wars amongst the most aggressive anywhere. This has pushed Canadians into playing a very dangerous game.
To hold down the size of their monthly payments, as home values continue to rise, record numbers of mortgage applicants are opting to take out loans that offer the lowest initial interest rates. The problem with these loans, known as variable-rate mortgages, is that their rates automatically rise along with the country’s benchmark borrowing cost. And by all indications, it’s about to go up potentially by a lot.
Governor Tiff Macklem acknowledged in comments Wednesday morning that inflation, which hit a 30-year high at 4.8 percent in December, is “uncomfortably high.” He said interest rates will need to rise to keep escalating prices under control. The bank removed its previous commitment to keep interest rates at the floor, with the Governor signaling to Canadians and markets that interest rates are now on a “rising path.”
An increase of more than one percentage point in the central bank rate would backfire on homeowners, driving the cost of their mortgages above that currently offered on conventional fixed-rate loans. To old hands in the housing market, the elements at play here — overstretched buyers suddenly hit with surging borrowing costs — are a cocktail for trouble. And while predicting a crash in the Canadian housing market has been an embarrassingly bad idea for two decades now, some are mustering the courage to raise the specter anew.
Playing Russian Roulette
Variable-rate loans are always cheaper than fixed mortgages, but now that the discount is the biggest it’s been in a decade, it’s tough for Canadians to pass up. Borrowers can save more than one percentage point in interest each month by opting for variable rates instead of fixed. That’s because fixed-rate loans are priced off government bonds, so they move with the financial markets.
So now, if a borrower puts 20 percent down on a C$ 1 million house– about the average price in Vancouver and Toronto– and takes out a floating-rate loan, they could save about $8,000 in interest payments in their first year if rates stay put.
Canadians seem to like those odds. According to the most recent data from the country’s banking regulator, floating-rate mortgages accounted for more than half of all home loans issued by banks in Canada each month from July to November. They’ve never accounted for more than 50 percent of new mortgages for even one month in those records, which go back to 2013, let alone five in a row.
Now, in Canada, floating-rate mortgages account for $372 billion, or a record 27.2 percent, of banks’ outstanding residential loans. As long as the Bank of Canada sticks to no more than four rate hikes of a quarter-point each, borrowers with floating-rate mortgages will still be saving money– and that’s what they’re betting on. But if the traders are right, some borrowers could be caught unprepared.
The danger for the Canadian economy will be if the millions of homeowners who’ve piled into variable-rate mortgages all engage in the same belt-tightening at the same time. Such a hit to aggregate consumer spending could end up putting some people out of work, and keeping up with rising mortgage payments might become tough.
A Slippery Slope
The concern isn’t that Canadian homeowners will be underwater on mortgage payments, which triggered mass defaults and foreclosures in the U.S. in 2008. When rates rise, most floating-rate loans in Canada allow borrowers to keep their monthly payments the same and pay down less principal to make up for the higher interest.
As fears of a housing bubble have grown, the government has imposed an added layer of protection in the form of a stress test, ensuring new borrowers have enough income to handle higher interest payments. It’s investors, whose participation in the housing market has grown faster than any other kind of buyer, who are more likely to sell. As of mid-2021, investors accounted for a fifth of all homes purchased in Canada, according to the most recent data from the central bank.
Investors look at their properties as a source of profit, so they may have fewer qualms about selling than owner-occupiers when the economics turn less favorable. Plus, the greater proportion of debt an investor carries relative to their income may make them even more sensitive to changes in interest rates, according to research from the Bank of Canada.
In late 2020, about 40 percent of investors were only breaking even– making that group completely reliant on price appreciation to earn a return, according to an informal survey of investment-property owners by Toronto’s Veritas Investment Research.
But investors, average home buyers, and mortgage brokers alike don’t seem to believe that the Bank of Canada will raise interest rates significantly. The Bank of Canada hasn’t had a policy rate higher than 1.75 percent since before the 2008 financial crisis, with rate-tightening cycles tending to be both brief and shallow. And as the pandemic still rages across the country, many investors see plenty of reason for the central bank to keep borrowing costs low.
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