What are these interest rates?

Jean-Paul Lam is Associate Professor of Economics at the University of Waterloo

In June, the Bank of Canada made an announcement that rocked the housing market. It raised its key rate to 1.5%, suggesting more aggressive hikes to come. He quickly kept his promise. In mid-July, the policy rate was raised to 2.5%. The decision makes sense: Canada not only has high inflation; he knows persistent and volatile inflation, at levels not seen for nearly 40 years. A pandemic plus supply constraints plus excess demand plus labor shortages? Economically, it’s a perfect storm. The bank is trying to calm things down.

When the key rate rises or falls, the interest rates of banks and other financial institutions generally follow the movement. This affects loan and mortgage rates offered to home buyers and mortgage holders. Homeowners may have been able to buy property at attractive mortgage rates during the pandemic, but they are looking at much higher monthly payments for at least the next two years. According to a recent Manulife survey, almost a quarter of Canadian homeowners say they will have to sell their property if interest rates continue to rise. There’s also a looming recession, which could spell disaster for already overburdened homeowners, many of whom may struggle to access credit to cover payments, particularly if they lose their jobs. What worries me is that today’s housing market shares many of the same attributes that contributed to the recession of the 1990s: rapidly rising house prices and the cheap and plentiful credit that accompanies permissive lending standards. We need an overhaul – and fast – to avoid the pitfalls of the past.

Canadians have suffered from a chronic housing shortage for more than 30 years, and the Canada Mortgage and Housing Corporation estimates that about six million homes will need to be built by 2030 to make things more affordable. The government must also tighten the lax lending standards of some Canadian financial institutions. Once upon a time, 30% of your income was the maximum acceptable to pay off your mortgage debt, according to the big banks. But before long, a wave of alternative lenders entered the market, some of which tolerate debt service ratios as high as 50%. These shadow banks, as they are sometimes called, must respect the 30% maximum of yesteryear. Some homeowners may not be able to get a mortgage approved, but they will be protected against debts they cannot repay.

Requirements like these are especially important when banks consider extending credit to Canadians who treat their homes like ATMs, leveraging their equity to buy more properties. In 2017, about two million mortgage holders extracted $89 billion in equity from their homes. Speculators build a debt-laden house of cards that can crumble in an economic downturn. Some of them need to be mastered.

These stricter debt-to-income ratio standards are expected to be accompanied by more rigorous stress tests, which are applied to loan seekers’ finances to calculate their ability to sustain debt at different interest rates. As of mid-2021, the Bank of Canada mortgage stress test rate is set at the contract rate plus 2%, or 5.25%, whichever is greater. Current stress tests were not stringent enough to deter homeowners who should not have taken on their current level of debt. It’s easy to see now.

It would also help address the significant problem of financial illiteracy in Canada. A TD Real Estate poll released in June found that a quarter of Canadians do not fully understand the impact of rising rates; a whopping 40 percent can’t tell the difference between variable and fixed interest rates. Outside of post-secondary finance programs, we don’t properly teach people the intricacies of economics and how it affects their wallets. For example, 70% of mortgage holders typically opt for a five-year fixed mortgage rate, while 30% choose a variable rate. Over the past six months, we’ve seen more people gravitate towards the cheaper variable rates. These might be more affordable in the short term, and even in the long term, if the economy is stable. But if we find ourselves in a volatile recession, homeowners who have chosen a variable rate will likely pay much more than expected.

The nuances of the market are difficult to understand without proper financial education and, especially now, not everyone can afford consultants to provide it. A few provinces have instituted compulsory finance courses at the primary and secondary levels. Rolling this out more consistently across the country would help future homebuyers weather the ups and downs of the economy. It’s unclear whether Canada will fall into recession in the coming months, but I don’t foresee a short-term reprieve. The main hope is that the housing market will experience a soft landing as it falls from its dizzying peak of the past few years. I’m skeptical, to be honest. Historically, drastic central bank action can lead to massive economic downturns. But if Canada sticks to the status quo, we will continue to perpetuate the predictable crises of our housing cycle of boom and bust.

This is part of Maclean’s Guide to the Economy, which appeared in the September 2022 issue. Read the rest of the feature, order your copy of the issue and subscribe to the magazine.

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