The article “Why it’s time for borrowers to accept the new normal of higher rates and plan accordingly” was originally published in Financial Post on November 29, 2022. PHOTO BY COLE BURSTON/BLOOMBERG FILES.
Interest rate normalization is causing the cost of debt to go up — and likely stay up
Mortgage interest rates have spiked in 2022, in some cases more than tripling from the lows of 2021. Five-year fixed and variable rates were in the 1.5 per cent range or less last year and are currently well over five per cent at the Big Six banks. So, what does this mean for young borrowers, rental property investors and older homeowners?
Borrowers with variable-rate mortgages have in many cases already been contacted by their lender to increase their mortgage payments. The Bank of Canada estimates that 50 per cent of variable mortgages — or a staggering 13 per cent of all mortgages in Canada — hit their trigger rates after they increased rates by fifty basis points in October. Variable rates have risen by 3.5 percentage points since March and are expected to rise another 25 to 50 basis points at the Bank’s December interest rate announcement. The central bank estimates payments for borrowers who took out variable-rate mortgages in 2021 had risen by 20 per cent on average by the end of October.
For younger people who finally managed to get into the housing market in recent years, the rise in rates is a particularly bitter pill. They are less likely to have extra savings kicking around to make a lump sum payment against their variable-rate mortgage, an option open to those who hit their trigger rates who want to avoid increased monthly payments. An important new year’s resolution for many young borrowers will be to look at their spending and plan for how to reduce costs in other categories to absorb the hit to their cash flow.
CIBC and TD have variable-rate mortgages that allow some borrowers to add some of their interest cost to their mortgage principal if their monthly payment is insufficient. This results in a negative amortization mortgage where the balance grows instead of declines. Most lenders do not allow this option for their mortgages. But even CIBC and TD borrowers will only have a temporary reprieve from higher payments. When their mortgages renew, their payments will likely rise.
Fixed-rate borrowers have breathing room for now. But many who took out mortgages over the past four years at 1.5 per cent to 2.5 per cent can expect higher payments when they renew in 2023 through 2026. A $500,000 mortgage at 1.5 per cent amortized over 25 years has a monthly payment of $1,999. At a 5.5 per cent mortgage rate, that payment would need to increase by 42 per cent to $2,836 per month to maintain the same repayment time horizon.
In retrospect, the mortgage stress test introduced in 2018 may not have been so unreasonable after all. Imagine how much higher home prices and debt levels would have risen in the absence of those measures?
A five per cent mortgage rate may have seemed unrealistic to many borrowers, especially young people, until the past few months. However, many people forget that the prime rate peaked at 6.25 per cent in Canada in 2007, just prior to the onset of the subprime mortgage crisis and resulting real estate collapse in the U.S. Many millennials were not old enough to have experienced six per cent interest rates firsthand fifteen years ago. The Bank of Canada also told Canadians that interest rates would stay low until at least 2023 when the COVID pandemic began in 2020. Combatting inflation with higher interest rates has proven more important than staying true to that statement, so some young people might be feeling surprised as well as misled.
Whether you have a variable-rate mortgage with increasing payments, or a fixed-rate mortgage that may require a higher payment at renewal, the key thing to do is plan for it now. Inflation may be causing the cost of living to go up, but interest rate normalization is causing the cost of debt to go up — and likely stay up. It means you need to re-evaluate your spending to stay on track financially. If you sacrifice saving for retirement to maintain your current standard of living, you may be short-changing your future self in your golden years.
Many rental property investors have been happy to buy properties with negative cash flow in recent years. A mortgaged rental property with more expenses than income is not necessarily a bad investment given part of the monthly cost is going to mortgage principal repayment, which is more saving than expense. But now that rates are such that some mortgage payments are not even covering the interest, the dynamics are changing. Some investors have ignored the cash flow for their rental property and relied upon perpetual appreciation. The national average real estate price declined 9.9 per cent year over year in October according to the Canadian Real Estate Association.
The International Monetary Fund reports that Canada’s home price to income ratio is the eighth highest out of 58 countries it tracks as of the end of 2021. Canada ranks tenth for home-price-to-rent ratio, reflecting relatively high prices and relatively low rental income. The Czech Republic takes the top ranking in both categories with countries such as Hungary, Iceland, Latvia and Turkey also showing signs of irrational exuberance as well.
Rental property investors should be more cautious about their capital growth expectations for properties they buy or already own. For those who are getting squeezed on cash flow as mortgage payments rise, they should consider increasing their mortgage amortization when their mortgage renews. This will reduce their mortgage payment and boost their cash flow (or at least decrease their loss).
Older homeowners who are expecting to downsize to fund their retirement should recognize the headwinds that could slow or stall real estate price growth, or even cause prices to fall further in 2023 and beyond. All homeowners, regardless of age, should be reminded that when home prices peaked in Canada in 1990, it took about 12 years to recover. Canada was in a recession for two full years during a time of high inflation and high interest rates due in part to the Iraqi war and an oil price shock.
Canada’s immigration target has risen significantly to 465,000 for 2023 and 500,000 by 2025. For the previous 30 years, the number of immigrants has been relatively steady in the 250,000 range. Housing bulls point to this boost in new Canadians as a reason for continued strong appreciation in home prices.
Despite the planned increase in immigration, intended to strengthen the economy, the Organization for Economic Co-operation and Development just forecasted Canada’s GDP growth at only one per cent for 2023, which is 19th amongst OECD countries, and 1.3 per cent for 2024, which is 25th. World GDP growth is projected to be 2.2 per cent and 2.7 per cent respectively.
My crystal ball is no clearer than anyone else’s, but the point is the high rate of real estate price growth in Canada for the past 25 years will be tough to build upon.
Savers should reconsider the choice to invest in their TFSA or pay down debt. They will need to earn a higher return on their investments than their mortgage rate. If they leave $100 outstanding on their line of credit at six per cent interest, the balance would be $134 after five years. If they invest in their TFSA at a six per cent return, the balance would be an equivalent $134 after five years. Conservative investors may do well to pay down debt instead of investing in their TFSA. Both debt repayment and investing will increase your net worth (calculated as assets minus liabilities). Aggressive investors may still benefit from investing over debt repayment, as long as their debt is mortgage debt and not higher-rate consumer debt, especially given stocks are on sale right now.
Young millennials may be too young to remember mortgage burning parties, which were a more common phenomenon in the 1980s when interest rates were higher. The near-constant decline in borrowing rates of the past generation made debt a more acceptable concept but rising rates may lead to more debt aversion. That, and the fact the meme stock bubble has burst and crypto is crashing, highlighting that wealth creation is typically a slow and steady race for some young people (and old people) who may have thought otherwise.
If a retiree is considering taking RRSP withdrawals or extra RRIF withdrawals to pay down debt, they should factor in the tax implications. If you withdraw $100 from a tax-deferred account, there is tax to pay on the withdrawal. You may be left with as little as $38 after tax, depending upon the province where you live and if you are a moderate to high-income retiree subject to OAS clawback.
Canadians have had to contend with increasingly higher mortgages for many years as real estate prices have risen. Now they have to budget for higher mortgage payments at a time when real estate prices are falling. Borrowers have grown complacent with debt aversion over the past 15 years, but all that has changed. Young borrowers, real estate investors, and older homeowners all need to find a way to manage their mortgage payments and real estate price expectations and accept the new normal of higher rates.
Jason Heath is a fee-only, advice-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever. He can be reached at firstname.lastname@example.org.