High house prices and debt loads associated with them are a major vulnerability to Canada's economy, the Bank of Canada said Thursday, warning buyers who bought during the pandemic that the impact of even slightly higher mortgage rates could be dramatic.
In its Financial System Review, the central bank said that while the country's financial system is strong and weathered the pandemic well, the economy remains vulnerable because of elevated debt levels tied to the country's increasingly expensive housing market.
"Even as the average household is in better financial shape, more Canadians have stretched to buy a house during the pandemic," Bank of Canada Governor Tiff Macklem said Thursday. "And these households are more exposed to higher interest rates and the potential for housing prices to decline."
The bank said that assessing risks related to high household debt levels has become more complex, but overall "the vulnerability has increased."
Renters vs. owners — by the numbers
Roughly two thirds of Canadians are home owners, and about half of them own their homes outright while the remaining have some sort of mortgage debt attached to it.
Raising lending rates slowed housing market
Home prices increased by about 50 per cent, on average, during the pandemic, as low rates allowed buyers to qualify for larger loans while still keeping the ongoing payments relatively affordable.
Much of those inflated house prices have been built on a foundation of debt. Almost one in five Canadian households are now considered "highly indebted," which means their debt to income ratio is 350 per cent or more, the bank says.
Prior to the pandemic, only one in every six were that much in debt. Barely 20 years ago, in 1999, only one out of every 14 households had that much debt.
"Those numbers mean that each rate hike will inflict more pain on the economy than it would have in the past," said Desjardins economist Royce Mendes.
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And those rate hikes have already started. After slashing its benchmark interest rate at the outset of the pandemic, in March of 2022 the bank began to raise its benchmark lending rate from 0.25 per cent at the start of the year to 1.5 per cent today, and the impact on the housing market has been almost immediate, with sales volumes slowing, along with average selling prices.
"Given the unsustainable strength of housing activity, moderation in housing would be healthy," Macklem said. "But high household debt and elevated house prices are vulnerabilities."
As part of its analysis of how resilient the financial system is in the face of various shocks, the bank examined what the impact of higher rates and lower selling prices might look like.
Mortgage costs could go up 30%
As part of that, the bank crunched the numbers on what might happen to the mortgages of recent home owners when their loans come up for renewal in five years.
The bank makes the assumption that in 2025 and 2026, variable rate loans will cost 4.4 per cent in five years, while fixed rate loans will be slightly higher at 4.5 per cent.
Those rates represent about a two-per-cent increase on where variable rates are today, and roughly equivalent to where rates are right now on the fixed-rate side.
Under that scenario, the 1.4 million Canadians who got a mortgage in 2020 or 2021 would see their median monthly cost go up by $420, or 30 per cent upon renewal.
The impact on fixed-rate borrowers would be slightly less, as they'd see their payments go from $1,260 on average when they first got their loan, to $1,560 a month at renewal, for an increase of 24 per cent.
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But variable rate borrowers are even more vulnerable, under the bank's thought exercise, as their typical monthly payments go from $1,650 a month when they got their loan to $2,370 when they renew. That's an increase of 44 per cent.
"If those in highly indebted households lose their jobs, they would likely need to reduce their spending sharply to continue servicing their mortgage," Macklem said.
"This is not what we expect to happen … But it is a vulnerability to watch closely and manage carefully," Macklem said.
Other risks beyond housing
Vulnerability to the housing market was only one portion of the Financial System Review, which is the bank's broad assessment of the health of the economy and its ability to withstand various shocks.
Some of the other vulnerabilities cited include cyber threats given the interconnected nature of the financial system and the fragile liquidity in fixed-income markets.
The bank also warned about the growth of cryptocurrencies and their volatility.
"Like other speculative assets, cryptocurrencies are vulnerable to large and sudden price declines. And recently, some stablecoins have failed to deliver on their promise of stability," Deputy Governor Carolyn Roger said.
The bank also says Russia's invasion of Ukraine has further complicated the transition to a low-carbon economy and assets exposed to the fossil-fuel sector, such as those found in the pensions and retirement savings of many Canadians, are in greater danger of being worth significantly less than anticipated.