When Interest Rates Inevitably Rise…
Manulife Bank hit an absolute home run with its report on consumer debt. The report was released May 23, in the form of a press release, which can be found here.
There was a lot of media coverage, which was focused on the finding that “70 per cent of mortgage holders are not able to manage a ten per cent increase in their payments.”
It’s not surprising that this got a lot of attention: it gets to the heart of an economic conversation that has been going on since at least the fall of 2008: “what will happen when interest rates inevitably return to normal levels?” “Will Canadians be able to afford their mortgages in the future?” “Are we on the verge of an economic crisis?” For about a decade, these concerns have been expressed repeatedly by economists (Canadians and foreigners), by the federal government and by the Bank of Canada.
Mortgage Professionals Canada has tried to get at the issue through our semi-annual surveys. We found that it’s a lot harder than it looks, and that it’s easy to get led astray.
For several years, we asked mortgage borrowers how much of an increase they could afford in their mortgage payments before they had difficulty making the payments. We also got disturbing responses: high percentages would not be able to afford higher payments. We reported on the results, and we got a lot of media coverage for it.
But eventually we realized that there was a major problem.
Strongly Motivated to Repay
The chief issue is that most mortgage holders are already paying more than they have to. Using data from our fall 2016 survey (on borrowers’ outstanding loan amounts, their interest rates and the original amortization periods) we can calculate how much they should be paying, and compare the required amounts to what they are actually paying. From this data, it appears that somewhere around 70 per cent of mortgage borrowers are paying more than their required amounts. This high percentage of “voluntary over-payments” includes people who have bought their homes during the last few years.
Across all mortgage holders (including those who are paying just the required amounts, as well as those who are paying extra), on average they are paying about $330 per month more than they need to, or about $4,000 per year. In short, very large numbers of Canadian mortgage borrowers have a lot of room to tolerate higher interest rates. This includes recent buyers (2014 to 2016) who on average are paying $300 per month more than required.
On reflection, this data from our survey doesn’t surprise me: I personally have believed for many years that I should pay as much as I could reasonably afford on my mortgage, to retire it as quickly as possible. The survey data tells me that I’m not alone in thinking this, and that it is in fact a widespread value among Canadians.
This brings me to my biggest issue with the Manulife survey (and with what we used to do in our survey, until we realized there was a problem). Since many Canadians are choosing to pay as much as they can afford, it is logical for them to say they could not afford to pay more!
BUT this is not the same as saying that they could not afford higher interest rates. Because they have been paying more than required, if their interest rate goes up, they have room to adjust their payments, and still be within their contracted amortization period.
We have drawn a second conclusion from our surveys: sometimes people are not answering the question in the way we intended. Some people really mean, “I wouldn’t like it if I had to pay more,” rather than, “I couldn’t afford to pay more.” This is not directly testable, but the data from the other questions in our surveys have pointed in this direction.
In a nutshell, there is no doubt that some mortgage borrowers do not have very much flexibility to afford higher interest rates. But the 70 per cent estimate in the Manulife report looks totally unrealistic. Unfortunately, the Manulife report is very appealing to the bears among us, who have been arguing that Canadian home buyers are being reckless or irresponsible. The data we have tells us the exact opposite, that a very large majority of Canadian home buyers are looking carefully at their situations, and are leaving themselves room to tolerate adverse future events.
Your insight is appreciated Will. The main purpose of Manulife Bank publishing our debt survey results was to draw attention to the debt truth: Many Canadians are unprepared for unexpected expenses and lack financial flexibility. The debt truth is that many Canadians feel they cannot afford a slight increase in their mortgage rates, which is shocking when we are experiencing historically low interest rates. As I indicated in my media interviews, mortgage lenders qualify borrowers at higher rates and are confident that most borrowers can meet a higher interest rate burden. Nevertheless, this will require an adjustment to their lifestyle, as Canadians, generally are not saving. This was particularly evident with Millennial homeowners.
Hello Mr. Dunning,
Your December 2016 Report, “Annual State of the Residential Mortgage Market in Canada”, says (if I read it right) that 35% of mortgagors did something to accelerate repayment (p.16) but here you say 70% are ahead of schedule. I am trying to reconcile the difference. Are people who choose biweekly accelerated prepayment considered to be ahead of where they would have been with a conventional monthly payment? Something else?
Thank you in advance.
Ralph Cramdown: 35% did something special during the past year, plus there are people who have taken actions in previous years, so that in the present they are paying more than they need to (eg. maybe they increased their payment a few years ago, and are still at an increased level). Is this clear? In total, 70% are currently paying more than they need to.
Regardless of the degree of apparent sentiment with respect to the ability to tolerate higher interest rates, we have not identified the cause. However, it is most certainly not low interest rates that cause poor money management.
There is a certain percentage of people that are terrible with their finances, irrespective of interest rates. The notion that people are driven to financial irresponsibility because rates are historically low is misguided and just plain wrong.
Debt service is the key indicator of responsible borrowing and Canadians for the most part have been and continue to demonstrate a high degree constraint in this regard.
Even if rates do go up, I doubt we will see much in the way of defaults. As long as people are working, and need somewhere to live, they will pay their mortgage. Discretionary spending will take the hit, I’m thinking.