More than 50% of mortgage arrangements were at variable rates this year. Other mortgages are “fixed rate” usually for 2-5 years, after which they adjust.
By Steve Saretsky, Residential Realtor in Vancouver, Stevesaretsky.com:
Another month, another giant rate hike from the Bank of Canada. Tiff Macklem and his team surprised the markets with a 100 basis point rate hike, the biggest since 1998, when the central bank tried to support a weak loonie.
Just two years ago, the Bank of Canada was rather irresponsible in encouraging the private sector to take on more borrowing, guaranteeing that interest rates would stay at zero until the end of 2023. Over the past four month, the bank took interest rates from zero to their target neutral rate of 2.5%, an incredible pace of change. Although the bank is adamant that it is applying “forward” interest rates, there is still 100 basis points of tightening expected for this year. This will have serious ramifications for the housing market, so let’s discuss that.
A mainstay of the housing market has been variable rate mortgages. They have been very cheap, on average more than 150 basis points cheaper than fixed rate mortgages [fixed for typically 2-5 years, after which they adjust, similar to ARMs in the US] This year. For this reason, we have seen an increasing number of new buyers opting for variable rate mortgages. Since the start of the year, more than 50% of new mortgage originations have been variable, a historically high figure.
If you opted for a variable rate mortgage in the last few months, you weren’t subject to the higher mortgage stress test. Remember that the mortgage stress test qualifies the borrower based on the minimum qualifying rate of 5.25% or their contract rate PLUS 2%, whichever is greater. In other words, with variable rate mortgages hovering around 3%, you would only be stress tested at 5.25%. Compare that to borrowers moving to fixed rate mortgages, and you’d be stress tested at almost 7% (5% mortgage rate plus 2%). Now you can see why a borrower would opt for a variable mortgage.
Now that the Bank of Canada has raised interest rates by 100 basis points, this will instantly take the typical variable rate mortgage to around 4.2%, which means you will be stress tested at 6.2 %. In other words, the average home buyer just lost about 10% of their borrowing capacity all at once.
It’s not hard to figure out what happens next. The pool of potential, or rather qualified, buyers is shrinking.
While no one knows where interest rates will end up, if you believe the market, overnight swaps suggest the Bank of Canada will raise the benchmark rate to 3.75% by the end of this year. . While I remain skeptical of the Bank’s ability to achieve this, it should be noted that this would equate to a 350 basis point increase in interest rates this year, which is approximately the amount required to trigger most fixed and variable rate mortgages.
In case you need a primer, 80% of all variable mortgages in existence are “fixed payment variable”. The monthly mortgage payment remains the same until it becomes negative (not enough principal repaid), this number tends to be around 350 basis points higher than the original contract rate. How many households are prepared or even aware that their FIXED payment variable mortgage can and will be reset higher when the bank inevitably raises rates in September?
Perhaps a subtle reminder that Canadian private sector debt/GDP stands at 235%, a figure even higher than what Japan experienced at the top of its bubble in the 1990s, when the Imperial Palace was worth more than the State of California.
It’s no wonder that home sales and prices continue to fall. The latest national housing figures for June show a 24% drop in home sales from a year ago. And benchmark prices fell 1.9% from a month ago, the largest seasonally adjusted monthly decline on record. Bigger than during the financial crisis, bigger than the mini downturn of 2017, and those numbers don’t take into account the last 100 basis point rate hike.
I don’t know how it ends, but assuming the central bank stays the course on the planned rate hikes, you can say goodbye to any idea of a soft landing. Housing and therefore economic forecasts remain extremely optimistic. By Steve Saretsky.
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