Exceptionally low interest rates throughout much of the pandemic were a boon for homeowners with variable-rate mortgages, which are closely tied with the Bank of Canada’s benchmark interest rate.
After the central bank slashed its overnight rate to just 0.25 per cent in March 2020, Canadian homeowners, on average, enjoyed variable mortgage rates below 2.4 per cent for about two years, according to the Royal Bank of Canada (RBC).
But that honeymoon may soon be over.
As interest rates continue to climb, borrowers will feel the pinch in their pocketbooks, economists warn. Rising rates could pose a challenge for homeowners as mortgage payments consume a larger portion of their monthly income.
Most variable-rate mortgages have fixed payment amounts, meaning homeowners typically pay the same amount each month. As interest rates rise, more of this payment goes towards paying off the interest and less towards the principal. (A notable exception: Scotiabank’s five-year variable mortgage payments may fluctuate as the prime rate changes.)
If interest rates continue to increase rapidly, some homeowners on “fixed payment amount” variable-rate mortgages may be forced to pay more each month.
“If interest rates go up enough, there could certainly be some borrowers who find themselves in a negative amortization position. In other words, their mortgage balance would be going up every month if they continue to make the same payments,” said Jason Heath, managing director at Objective Financial Partners Inc.
“The payments would not even cover the interest.”
However, RBC senior economist Robert Hogue stresses that monthly payment increases for variable-rate mortgages are rare and depend on a number of factors, including when the loan was taken out, the terms of the mortgage and how far along a borrower is in terms of repayment.
“Theoretically, yes, monthly payments could potentially go up,” he said. “But it would be only for a very small minority of people.”
The Bank of Canada’s overnight interest rate sits at one per cent after a 0.5 percentage point hike last month — the most significant increase in the central bank’s rate since 2000. That raise came just a month after the bank announced a 0.25 per cent hike to the benchmark rate.
Hogue expects the Bank of Canada to raise rates by 0.5 per cent in both June and July, followed by subsequent hikes of 0.25 per cent.
“We’re expecting the overnight rate to reach 2.5 per cent by the fall, which is a substantial increase relative to where it is today, at one per cent,” said Hogue.
The Bank of Canada is set to make another interest rate announcement June 1.
Since fixed-rate mortgages are typically tied with the bond market, not the Bank of Canada’s benchmark interest rate, those types of mortgages will fluctuate differently than variable-rate mortgages.
Both Hogue and Heath predict fixed rates will increase “a little bit higher,” but less than variable rates.
Borrowers with a five-year fixed-rate mortgage who are renewing their mortgage this year will not notice much of a difference, said Hogue, adding that fixed-mortgage rates have returned to pre-pandemic levels following a dip during the pandemic. Fixed rates are now comparable to where they were five years ago, he said.
Borrowers who started a fixed-rate mortgage term during the pandemic and those whose contracts are up for renewal this year, will feel the greatest impact from the rate hike, he said.
Ian Calvert, vice-president and principal at HighView Financial Group, said Canadian families will likely start to cut back on discretionary spending to absorb the higher mortgage rates.
“If your mortgage payment represents more of your take-home income, then you will have to see sacrifices in other areas, such leisure and vacation and dining,” he said. “Servicing debt is now becoming a different scenario than it has been in the past few years.”
However, the mortgage stress test, introduced by the federal government in 2018, will help ensure borrowers can weather the storm if rates increase, Calvert said.
To qualify for a mortgage loan, Canadians must prove they can service their mortgage if interest rates rise to 5.25 per cent or two per cent above the rate negotiated with the lender, whichever is higher.
“It’s never going to be a perfect science, but it will mitigate risk by building in a procedure to see if a borrower can service this loan if rates do rise,” he said.
Aled ab Iorwerth, deputy chief economist with the Canada Mortgage and Housing Corporation, said the higher mortgage rates will likely put a “dampening effect” on house prices and housing demand.
“I would expect sales activity to decline in the near future as we see mortgage rates go up. I think households will be thinking twice about taking on too much debt,” he said, but noted additional housing supply is needed to address the affordable housing crisis in the long term.
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