Increasing Interest Rates
Positive outlook for the economy, or another financial disaster?
fter almost two years of the pandemic, Canada’s economy has been in a fluctuating market due to lockdowns and business closures. But as Canada begins to move into recovery, we will be looking at major factors that will shape Canada’s economic outlook. In 2020, Canada saw the steepest decline in its real domestic product by -11.3% and unemployment rates by -8.1%. Due to major job losses, along with the downfall of investments, investors feared that their investments would be worth nothing, leading them to invest less and liquidate more. To relieve this pressure, the Bank of Canada and the Government of Canada distributed support grants and decreased interest rates on loans to regain investor confidence in retail and real estate investments.
As the pandemic is slowly ending due to national vaccination efforts and easing public health restrictions, the Bank of Canada wants to increase rates on loans as part of the economic recovery plan. As many people suffered tremendous amounts of financial loss—along with these increasing rates, how will it affect the loan payments, and will individuals be able to afford these payments?
Increase in Residential Home Prices
On March 27th, 2020, the Bank of Canada lowered the interest rate to 0.25% from 1.75%. The Bank of Canada's reasoning behind this decision was to promote Canada's economic and financial welfare during the post-pandemic recovery period. On average, Canadians saved 14.75% of their disposable income during the pandemic, which is five times as much as in 2019. Moreover, according to a study by Scotiabank, structural housing (homes that are available to sell to investors) are short by 2 million units compared to previous years. With more people having increasing cash on hand now, low-interest rates, and high demand for homes, real estate investments are going through the roof.
In July of 2021, Canada saw an increase of 15% in housing transactions and an increase of 26% in average sale price compared to June 2020 (see Exhibit 1).
Exhibit 1 // Source: WOWA Canada, Canadian Housing Market News
With a decrease in interest rates, a substantial number of investors became eligible for mortgage loans that they could not afford. That was especially true in June 2021. With the inflation rate at 3.6% and a high cost of living, individuals who bought expensive homes might not be able to afford them down the road if their monthly payments become more expensive through increasing rates.
Affordability of Increasing Interest Rates
As interest rates are projected to increase, it is important to see if investors can afford their payments.
The Bank of Canada interest rate peaked at 1.75% before the pandemic hit, and then it went down to 0.25%. But now, amidst the robust recovery of the economy, interest rates are projected to climb over their peak and hit 2.00%. In an interview, the governor of the Bank of Canada, Tiff Macklem, concluded that the home prices are not sustainable and warned households against taking on too much mortgage debt, as individuals may not be able to afford the increased rate payments.
At the start of the pandemic, low-interest rates motivated investors to take on more debt as they were able to pay for the cheaper payments. But now, with more expensive payments, investors’ incomes and current assets do not provide enough leverage for them to make the higher payments, leading to increasing debt. To prevent investors from over-leveraging and going into more debt, borrowers and lenders both have a role in ensuring that homeowners can afford to pay off their debts at higher rates.
While having a growing household vulnerability to inconsistent payments, policymakers could have a reason to increase rates, creating the risks of slow growth or even a housing price correction.
The What-if?
In 2001, when Canada was going through a recession, the Bank of Canada lowered interest rates to increase investor involvement in real estate. The low rates allowed homeowners to carry a larger amount of mortgage debt, which was seen again in 2020. This increased demand for housing but also raised the risk of interest payment affordability. Thus, the question that needs to be answered is, will investors be able to consistently pay their payments, or will they go into debt and must foreclose or dilute their investments? With debt among investors rising, the attraction of investments will decrease and cause a market downfall.
If a correction happens again, the government is well-prepared to handle it and has put more limitations on loan lending compared to the 2000s. Canada now has a sound risk management policy on giving out loans to eligible investors who have a stable income to fall back to with low debt. To prevent ineligible lending, Canada also has regulations across a range of financial system participants. These risk management regulations not only manage how financial institutions work but also make sure that risks are only taken if they have a high probability of profitable payback.
Even a well-thought-out framework sometimes has faults in its system. The household debt and Canada’s red-hot housing market have always been considered major vulnerabilities, especially when it comes to the quality of new mortgage borrowing. According to the Bank of Canada Financial System Review of 2021, the share of new mortgages with a loan-to-income ratio above 450% rose by 22% of all mortgages in the second half of 2020, which results in bad quality mortgage borrowing. If a major unemployment loss or a sudden drop in the price of homes were to occur, highly indebted homeowners have less flexibility to deal with an upcoming rise in costs on their mortgages. This would be the case because their income would not be able to afford their payments on the mortgages.
Through the pandemic, household finances have still been intact due to government support grants and programs. However, as the mortgage debt and monthly payments secret increase, some homeowners are at risk of overleveraging. If there was an increase in interest rates and the homeowners could not afford their payments, this could lead to the foreclosure of the property and eviction.
As the government started offering benefits, many homeowners took part in low-interest rate investments. But if the payments on those investments cannot be made—along with many foreclosures—the equity gains in the housing market will start decreasing. Home equity values will then become overpowered by the rising mortgage rates and mounting loans. So, the lenders would keep the houses in their portfolios, and with the late mortgage payments and large debts, the lenders would stop loaning money and try to recover their debt. This happened in 2008, with banks being overleveraged with a high liability rate, which resulted in the collapse and therefore caused a significant financial crisis.
Looking out into the future, regulations, even with new ones being instated, have not been as effective. Thus, decreasing interest rates was a short-term solution to increasing investor attraction during the pandemic. In the period of post-pandemic recovery, the Canadian government and its citizens should be prepared to counter any consequences that our fragile economy and markets create.