Our interest in rising rates

Many Canadians today are opting for variable rate mortgages. What happens if interest rates rise and homeowners cannot pay?

Nobody knows exactly when interest rates will go back up, but we will have to face a rise sooner or later. The problem is that Canadians are carrying more debt than ever, and the housing market, a key economic driver for many years, is showing signs of slowing down, as even the most optimistic forecasters now call for modest growth in house prices for 2015 and a so-called soft landing. The Canadian economy has been bolstered by the low interest rates of recent years, and now it depends on them to function.

What would happen if rates began climbing by one, two or even three percentage points? What would be the effect on the housing market? How many Canadians would no longer be able to pay their mortgages? Even the governor of the Bank of Canada, Stephen Poloz, recently admitted in a CBC interview that Canadians have taken on so much debt that any uptick in interest rates could send shock waves through the economy.

Does our economy depend on low interest rates? And how much of an increase could it withstand without collapsing?

Very little wiggle room

Consider the following: you just purchased a house for $350,000. If you made a $35,000 down payment and obtained a 25-year mortgage with a variable interest rate of 3%, your monthly payment is $1,530. If by some misfortune the interest rate rises to 5%, your payment will then be $1,886. Will you be able to find the additional $356 each month?

"People are becoming increasingly dependent on the Bank of Canada’s key interest rate [which influences the banks’ prime rates]. This phenomenon is striking because people are now looking for the lowest payments even if for a shorter period of time," says Stéphane Bruyère, a broker at Mortgage Architects in Montreal. "Currently, 80% of my clients opt for variable rates. When a variable rate hovers around 2% or 3%, very few people want a fixed five-year rate, and fewer still want a 10-year rate, even if it is barely above 4%."

Elena Jara, director of education at Credit Canada Debt Solutions, recalls when interest rates rose by a quarter of a percentage point a few years ago. "The increase mainly affected people with variable rate mortgages. Even though the increase was only a quarter of a percentage point, many people found it difficult to make ends meet, as monthly payments went up by more than $100 in some cases. They had to cut back on outings and groceries. A rate increase, however small, can have a huge effect on our economy."

Bruyère adds, "People now live on very tight budgets. An increase of just 1% would be problematic. Many people would find it even more difficult to get by, especially with the forecast increase of service costs. A 2% or 3% rate hike would be disastrous for them."

Real estate’s domino effect

Many Canadians are concerned about how rate increases impact the housing market and, in turn, the economy as a whole. A number of organizations and media — including the OECD, the International Monetary Fund and The Economist — and many leading economists have predicted that the Canadian housing bubble will burst, especially since home prices have risen much faster than average salaries.

The likelihood of the bubble bursting is debatable. However, one fact remains: the economic repercussions of a housing catastrophe should not be taken lightly. According to data from Ben Rabidoux, president of North Cove Advisors Inc., a research firm that specializes in the Canadian economy and the real estate market, almost half (45%) of Canada’s GDP growth since 2000 is directly linked to construction, finance, insurance, real estate and similar sectors. "It’s substantial and very worrisome. Today, a huge portion of the economy is sensitive to interest rates," says Rabidoux. In recent years, the real estate market — and its domino effect on numerous industries — has boosted the economy, but the opposite is also possible. According to Rabidoux, "Industries that depend on real estate currently generate close to 27% of the annual GDP, compared with 23% in the early 2000s. These industries tend to expand when the housing market is doing well, but they also contract when it cools off."

Moreover, spending on renovations has doubled in real terms (adjusted for inflation) in a decade. Most of this spending is financed through home equity lines of credit, which are also very susceptible to interest rate fluctuations. "If interest rates were to rise, I don’t think we would be in for a soft landing," says Rabidoux. "It would be rather brutal. A 1% increase would result in a decrease in real estate sales of approximately 20% for a while."

Not all experts are as pessimistic. "Having debt is one thing, but what matters is whether you’re able to pay it off," says Stephen Gordon, economics professor at Laval University in Quebec City and a blogger for Canadian Worthwhile Initiative and Macleans.ca. "The crisis in the US was triggered by, among other things, the sudden rise of the share of disposable income Americans needed to cover the increase in their mortgage payments. However, the debt service ratio remains the lowest it’s been in more than 20 years in Canada. Even though the amount of debt has increased, Canadians still have the same wiggle room, more or less, to pay their mortgage."

Of course, no one wants higher interest rates, he says, but we wouldn’t witness a financial crash like the one in the US. "That doesn’t mean there’s no cause for concern, but the soft-landing scenario, especially for the housing market, remains more likely," Gordon says.


Will rates go up?

"Why would interest rates increase?" Gordon asks. "Under what circumstances would this happen? Rates increase when the economy is strong, inflation is close to the Bank of Canada’s target and the job market is doing well. Let’s not forget that all these factors are good news."

Alex Koustas, an economist at BMO Capital Markets, agrees. "We would only see a more marked increase than anticipated if the economy were progressing more quickly than expected; this would mean higher salaries, less unemployment and a better GDP. These positive effects would offset the negative impacts of a rate hike."

It is worth noting, however, that the Bank of Canada mostly controls short-term interest rates, not the overall economy. In 2013, when the US Federal Reserve announced it was tapering off its quantitative easing program of printing money and buying bonds, the yield on US bonds increased, as did the yield on Canadian bonds, which, historically, closely reflects that of US bonds. In addition, these US bonds, which mature over five years, are used as a benchmark for many mortgage loans. As a result, interest rates can rise due to external factors, despite the will of the Bank of Canada.

According to Rabidoux, "Over a three-month period in 2013, mortgage rates rose to 3.8% from 2.8% for five-year, fixed-rate loans. This was a trying time for mortgage brokers and real estate agents. Many Canadians renegotiated their mortgages for the long term out of fear that rates would keep rising." If a 1% increase causes panic in the mortgage market, he adds, this says a lot about how sensitive Canadians are to interest rates.

That being said, an interest rate increase would still have its advantages, especially for pension plans, which invest considerably in bonds, and for retirees. In general, Canadians do not save enough for retirement or unexpected expenses. Higher interest rates would encourage saving and deter credit purchases.

In addition, a growing number of Canadians would plan better to allow for some leeway in case rates do go up, Jara adds. "Few consumers are taking such precautions right now, which makes many of them very vulnerable. A rate increase would make Canadians more mindful of the possibility of further rate increases; we are lying to ourselves when we believe interest rates will remain the same."


Even though consumer debt is growing at a slower pace than income, Canadians are carrying more and more debt. According to a BMO report, the average Canadian household debt rose to $76,140 in 2014 from $72,045 in 2013. Alberta is the province with the highest level of indebtedness: for the same period, household debt increased 40% to $124,838 from $89,026. This situation is mostly attributable to rising house prices and the accompanying mortgages. According to StatsCan, Canadian household debt hit a record high, hovering at 163% of our disposable income. So, the average Canadian owes $1.63 for each dollar earned in a given year. Credit reporting agency TransUnion estimated that during the five-year period following the financial crisis, inflation rose by 9%, but debt other than mortgages, such as credit card debt, car loans and lines of credit, rose by 37%.