We wait six months for this day to arrive and when Canada Day lands on a weekend, it is extra special. Time to relax and get out of the house or condo to enjoy the outdoors. For many Canadians, however, this weekend might also be one of reflection on how much their dwelling is actually costing these days. Where the focus has been primarily on visible costs, like energy, it is now shifting to the expense of servicing the debt associated with one’s property. The last time Canadians were this focused on borrowing costs and their dwellings was back before the Financial Crisis, yet we might be looking at something more severe, at least domestically.

 

In the last several weeks, Ally and I have looked at monetary policy directions being taken at the Bank of Canada and the Federal Reserve, but we tend not to spend as much time examining what is happening to administered borrowing costs. Let’s start with term mortgage rates. The Bank of Canada conventional 5yr mortgage rate has climbed from 4.8% at the start of the year to 6% today. The last time we were above this level was in 2010, as the rate came down (thanks to a recession) from a peak of 7.5% in 2007. Now, I know you are going to look at this and say that the posted rates aren’t this high, and you are right. In most cases, the rates offered will be significantly lower than the rate indicated by the Bank of Canada. The purpose of the latter is to assess the ability of a homeowner to carry a particular mortgage. Still, even prevailing rates have shot up in recent months to levels not seen by a large contingent of the younger population out there.

 

 

The other important consideration when looking at where mortgage rates are today is what the actual term of the mortgage is and when it was entered into. If someone signed for a 3yr mortgage back in 2019 and is renewing today, the bump-up in cost is not that dramatic. However, if a homeowner took out a 5yr mortgage in 2017 and is now looking at renewal, the rate could be about 30% higher. In fact, the period from 2015 to 2016 was marked by extremely cheap money as bond yields tumbled to levels even below what we saw after the Financial Crisis, in the wake of continued loose monetary policy. Those days temporarily ended in 2017 and 2018, but returned in 2020 and 2021 in response to the pandemic and, while the Bank of Canada conventional rate did not get back to the lows of five years ago, actual rates did. 

 

That fueled an explosion in mortgage debt to a record in excess of $1.7 trillion last year, as home prices soared. The wealth effect created by the expansion in housing-related net worth definitely supported the Canadian economy, but the opposite is taking place as that mountain of debt comes face to face with higher interest rates. We already know just how sensitive this economy has become to interest rates by the sharp turn taken in the housing market, with demand waning and prices pulling back. In terms of how this may play out for Canada, we can look back to what happened in the US.

 

 

 

After the recession in 2001, the ratio of household debt to personal disposable income stood at about 100%. As the housing boom developed and speculative behaviour took hold, this ratio climbed to above 130% by 2006. It would eventually peak at just over 130%, just as interest rates were starting to plunge in response to the crisis that had ensued. Bankruptcies soared as home prices fell and the balance sheet correction would take the ratio back down to pre-crisis levels, thanks also to accommodative policy and a recovery in household incomes.

 

 

 

At the time the US debt to income ratio peaked, Canada’s household debt was sitting at roughly 150% of household disposable income. The problem is that Canada didn’t experience the type of balance sheet correction during the Financial Crisis that engulfed the US and, as a result, debt to income continued to rise. It would reach a record high of 181.14 in 2018 and then decline during the first year of the pandemic. The decline didn’t last long, and in the first quarter of this year it rose back to 181.10 – just shy of the record. Given that borrowing costs have just stated to move significantly higher, I suspect the ratio will break that record when the second quarter statistics are reported.

 

Breaking records doesn’t necessarily mean we are going to see a major calamity in Canadian housing. Interest rates were even higher than they are today back before the Financial Crisis and we managed to dodge the bullet, but with debt now 30 percentage points higher relative to income, it is going to be a lot harder to dodge it this time. Most economists believe that official rates and administered rates will continue to climb over the remainder of this year, which will mean that the Bank of Canada overnight rate will push above 2% for the first time since 2008. That also means that the prime rate will exceed 4% (now currently 3.7%).  This, in turn, will make adjustable-rate mortgages more expensive as well as lines of credit backed by residential property.

 

 

 

Federal regulators and the Bank of Canada have both looked for ways to stem the aggressive build-up of debt in this country and have highlighted the risks to the economy of not brining leverage under control. Since the pandemic, Canadians have been tapping into a growing home equity pool to increase their spending power and consolidate debt from higher-rate credit cards. We have seen this before, where an individual will pay off the balance from a card that charges 20% with a home equity line of credit that is at prime or prime plus a percent. If the credit card was left at home, this would be a happy ending. Unfortunately, zero balance credit cards have been tapped into even more now that monthly SERB payments have ended and inflation has risen.

 

This is one reason why the Office of the Superintendent of Financial Institutions came out this week with a new rule concerning mortgages that are paired with revolving lines of credit (sometimes referred to as HELOCs). If such loans exceed 65% of the value of the home, then individuals will be required to pay both principal and interest on any combined loan amount until it is under that threshold. Just over 10% of HELOCs outstanding fall into this group so the amount is not trivial. If home prices were rising, this new rule would not be a big deal, but when they are in decline it will be harder for some to stay below the 65% mark. If we were to see a significant correction in home prices, then this could become a vicious cycle for those who bought homes near the high or who simply ramped up leverage to take advantage of higher valuations for their existing home. With interest costs taking up a larger percentage of a scheduled mortgage payment, the need to increase principal payments will put an even heavier burden on some households. Again, this doesn’t mean that the housing market suffers a major setback, but it does mean that consumer spending is going to be challenged.

 

On behalf of the Pyle Group, have a wonderful Canada Day weekend.   

 

Andrew

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.