That being said, I also recognize that the Bank of Canada is between a rock and a hard place. On one hand, they have their mandate to maintain inflation between 1 and 3% (targeting 2%). On the other hand, Canadians have been amassing serious levels of debt, with some of the latest estimates pegging Canadian debt to disposable income at just over 177%.
That is, Canadians tend to owe $1.77 for every dollar of income they earn -- but why does this cause trouble for the Bank of Canada?
Well, as the Bank of Canada increases the overnight rate to combat inflation, this will also increase debt servicing costs for many Canadians, increasing the proportion of their income that goes towards interest costs. Depending on how rapidly the Bank of Canada acts - this could push certain Canadians into insolvency
According to an Ipsos survey from 2019, almost half of Canadians are $200 or less away from insolvency. One can imagine that since the pandemic, and increasing prices all around, this outlook has not improved.
Now, with the picture painted that Canadians are heavily indebted, with many on the verge of financial ruin - let's look at the housing market - That is, if the Bank of Canada were to increase interest rates, what impact will this have on the mortgage payments being made by Canadians?
First, important to differentiate between variable and fixed-rate mortgages.
Variable-rate mortgages are linked - somewhat - to the Bank of Canada's overnight rate. Speaking in generalities, if the Bank of Canada increases the overnight rate by 25 bps, then the variable rate mortgage also increases by 25bps -- meaning the debtor's payment will have to increase.
Fixed-rate mortgages are a little different - with a fixed rate, the debtor is locked into a given rate for a certain term (say 5 years). With this arrangement, the debtor's payments are constant over the term of the mortgage but will be re-negotiated upon renewal (typically every 5 years). That is, an increase in interest rates today will have no impact on the holder of a fixed-rate mortgage - until renewal.
That is to say, a change in the overnight rate will impact variable rate holders immediately, but will impact fixed-rate holders over time - as they renew at new, potentially, higher rates.
So let's see what the impact on monthly mortgage payments would be if we received a 100bps increase in interest rates (a conservative forecast).
To do so, let's begin by determining the monthly payment on mortgages of various amounts if the current mortgage rate is 2.5% (a typical fixed-rate amount).
While not interesting on its own, let's re-work out what the monthly payment would be at a rate of 3.5%
Here we see an increase in monthly payments, but what is the magnitude change in monthly payments?
Thus we see that an increase of interest rates (from emergency lows) by 100bps, which still leaves at historic lows, causes drastic increases in the monthly mortgage payment for many Canadians.
Given, as we saw, that many Canadians are within $200 of insolvency we can now see why the Bank of Canada may be so hesitant to begin rapidly increasing interest rates. Even with this - this is just looking at the impact on mortgage payments, many will also be witnessing a potential increase in car loans, student loans, line of credit, etc. All together causing potential trouble for many Canadians.
Of course - all this assumes that these payments (and prices) are rising, but incomes are staying constant - Of course, this is not true, as we witness inflation, there should also be increased pressure for wages to rise offsetting some of this pain - Although, we just showed a 100 bps increase in the lending rate would cause an 11.5% increase in monthly payments, unlikely that incomes will increase that much.
Feel free to comment below with your thoughts
No comments:
Post a Comment