Future Rate Hikes <> Housing Doom

Canada’s housing market is like that car in the movie Christine. You can smash it, run it off the road, blow it up and it keeps coming back.


Crash predictors have cried wolf so many times that folks are becoming progressively immune to bubble chatter. Interest in terms like “housing bubble” has steadily waned in recent quarters, as depicted below by Google Trends.

But make no mistake, a sizable minority of Canadian real estate is overvalued based on multiple objective measures. If you consider the Conference Board to be a reputable source, however, it’s not quite as bubbly as some would argue.

If you’re interested in the logic behind the Conference Board’s conclusions, read this admittedly skimpy report summary.

The key takeaway is that the greatest danger to home values may be future rate increases. Those are guaranteed to come (one of these days).

Conference Board economist Robin Wiebe reasons that, “Mortgage costs, not just house prices, are the principal deciding factor for potential homebuyers.” Right he is. And, more specifically, rates and lending rules (e.g., the maximum amortization) are crucial determinants of mortgage costs…and thereby housing demand.

payments-mortgagePayment affordability has propped up real estate values for years now, driven predominantly by historically low interest rates. That’s partly why people can still manage to buy homes at record-high prices.

But higher rates could change that to at least some degree.

The Conference Board, like so many other econo-predictors, sees a 200 basis point rate hike by 2017-2018. If that happens, someone buying today’s average home with 5% down would see their payments jump $359 (19%) at renewal in five years.

Assuming 2% annual wage growth, someone with 5% down and the average household income would see the maximum mortgage they qualify for drop from roughly $484,000 today to $450,000 (-7%).

Would that finally be enough to set off a downward spiral in home prices? Well, the last five years of mortgage rule tightening has damaged affordability more than that and prices are still setting records.

Affordability-and-RatesUndoubtedly, a 7% drop in across-the-board affordability would be a heavy piece of straw on the camel’s back. And the Bank of Canada knows it. It is keenly aware of how leveraged (addicted) consumers are to low interest rates.

That’s why, short of an acute outbreak of inflation, the BoC will likely take rates up methodically (e.g., 75-100 basis points) and then stop and judge the fallout.

At that point, if housing begins an ominous slide (and threatens to bring the economy with it), the BoC will have 150-175 basis points of monetary easing power to revive it.

For that very reason, and thanks to persistently high credit quality in this land of ours, all is not lost…even if rates do what they’re “destined” to do: rise.

Sidebar: The Conference Board says mortgage payments in Toronto consumed less than 20% of average household incomes in 1993, the same as in 2013. Five-year fixed rates have tumbled roughly four percentage points in that same time span.


Rob McLister, CMT (email)

  1. The discussion here is really about “renewal risk”, which has been the focus of the discussion for the past 5.5 years. But, a 2-point rise in mortgage rates (or even a 1-point rise) would hit sales long before it starts to show up in renewals. It seems to me that the impact on housing and the broader economy would show up fairly quickly, and this interest rate sensitivity will prevent the rate increases that are being talked about. Therefore, I just can’t see interest rates rising far enough and long enough to create renewal problems.

  2. Hi Will,
    Assuming a 200 bps hike, renewal risk would primarily apply to the minority who: (a) put down less than 9%, and (b) choose a 5-year term. Those are the homeowners who wouldn’t be qualified at posted and who wouldn’t have enough equity at renewal to re-amortize.
    Of those folks, one must estimate how many might not have the capability to absorb 19% higher payments. Your research found that just 2,000-2,500 of 2010 insured buyers would have an extreme total debt service ratio (i.e., a TDS over 45%) if rates rose to five percent. That’s a drop in the bucket of Canada’s ~9,500,000 homeowners.
    The renewal risk discussion gets more play than it deserves. That is, unless one believes rates could fly significantly higher than 5.00%. And a sustained 5.00%+ average mortgage rate seems out of character with ~2% long-term GDP growth and 2% inflation targeting.

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