How the Rising Overnight Rate Will Impact Mortgages in Canada
On March 2, 2022, the Bank of Canada (BOC) raised its overnight lending rate for the first time since 2018. This move comes as no surprise given the current supply chain crisis and the continued rise in inflation across Canadian markets. As of yet, the overnight lending rate was increased from 0.25% to a new rate of 0.50%, but there is no doubt in my mind that this figure will continue to increase over the next couple of months.
What Causes the Bank of Canada to Increase its Overnight Lending Rate?
The Bank of Canada is in charge of implementing monetary policy by modifying the overnight lending rate to control short-term interest rates. It uses this ability to control inflation and keep the Canadian economy on track.
In Canada, the ideal inflation rate is thought to be in the range of 2 to 3 percent. In January of 2022, the inflation rate in Canada surpassed 5 percent for the first time since 1991, hitting a 30-year high at 5.1%. This follows an inflation rate of 4.8% in December of 2021, a trend that has been growing consistently above the 3% mark since April of 2021. Since high inflation tends to hurt individuals financially and economies as a whole, the Bank of Canada needs to step in to help manage the situation.
The BOC is expected to continue steadily increasing the overnight rate over the next few months. This rate is expected to hit 1% by this fall and 1.75% by early-to-mid 2023. By this point, we can only hope that inflation will be somewhat under control.
What Does This Mean for Mortgage Rates in Canada?
This development marks the first of several expected interest rate increases, and it is very likely that the prime mortgage rate will soon follow suit. We can expect both variable mortgage rates and variable home equity lines of credit ( HELOC ’s) to increase in cost as they are tied directly to the prime interest rate.
Predicting the potential rise in fixed interest rates is slightly more difficult as they are not directly tied to the prime rate. Instead, fixed mortgage rates are set by chartered banks, based mostly on the bond market.
Authorized banks use the Government of Canada's mortgages and bonds as a means of investment to generate their own profits. Bonds serve as collateral for the losses a bank incurs in its mortgage business. As a result, banks determine interest rates on fixed mortgages based on the interest earned on their fixed income investments. They use the money they get from borrowing to offset the losses they incur on the mortgage side.
As the Canadian bond markets continue to yield high returns, we expect the pattern of regular increases in fixed interest rates that was observed in 2021 to continue into 2022.
How Will These Expected Rate Increases Impact Borrowers and the Canadian Mortgage Market?
On June 1, 2021, the stress test qualification rate rose to 5.25%. This meant that in order to pass the mortgage stress test, borrowers now had to qualify at 5.25%, the benchmark interest rate used to charge borrowers for eligible, qualified, insured, and uninsured mortgages, or at their current contract rate plus 2%— whichever was greater.
While interest rates were low, the stress test served as a great way to ensure that renewing borrowers could continue affording their monthly mortgage payments, even if interest rates were to rise. Now that interest rates are expected to continue rising throughout 2022 and even 2023, the mortgage stress test qualifying rate will also likely increase.
This increase in the stress test qualification rate, combined with the constant growth of home prices, has made qualifying for a mortgage more difficult than ever before, especially for new homebuyers.
Homeowners who are looking to refinance their current mortgages are also having trouble going through traditional banks and other AAA lenders when trying to access available equity in their homes.
At Clover Mortgage , we have already seen a strong push towards the alternative lending space as home prices soared in 2021. As more and more borrowers were being denied the mortgages they needed by banks and other AAA lending institutions, our brokerage has seen a steady increase in alternative “B” mortgages and private lending . The recent and upcoming rate increases are expected to further exacerbate the growth in demand for alternative lenders.
As it becomes increasingly difficult for borrowers to qualify with banks, we will see more and more borrowers turn to more flexible lenders. It's safe to say that credit unions, trust companies, and private lenders will begin taking some business away from commercial banks. However, it's important to note that mortgages from alternative lenders tend to come with additional costs and higher interest rates. Not all borrowers can afford to pay these additional fees.
Another downside to rising interest rates is that many borrowers who initially qualify and pass the stress test when they first get their mortgage accumulate significant debt or experience reduced income during the term of their mortgage. This can make it difficult for some people to keep up with their mortgage payments as their interest rates and mortgage payments go up at renewal time. This can cause many homeowners to default or be forced to sell their homes, leading to more inventory on the market.
Due to the increased costs that borrowers face with alternative lenders, many homebuyers end up reconsidering and delaying their home purchases. Furthermore, when mortgage rates increase by several percentage points at the time of renewal, homeowners may be forced to put up their properties for sale. Both these factors can lead to increased inventory and reduced buyer competition in the Canadian real estate market. While this could lead to a slower rate of home price growth, we shouldn't expect home prices to fall anytime soon.
What Can the Government Do to Make Mortgages More Affordable for Canadians?
There are a few key things that the government can do to make mortgages more affordable for homebuyers and homeowners across the country:
- One thing the government can do is reduce or eliminate exam stress. The stress test is designed to help protect borrowers against future interest rate hikes. As rates are still at historic lows and are expected to continue to rise, this scenario is unlikely.
- Another practical step the government could take is to re-introduce the 40-year amortization and allow uninsured mortgages to qualify for the full 40 years. By reintroducing 40-year amortization on uninsured mortgages, borrowers will be able to increase amortization from the current 30-year maximum for charter banks to 40 years. This will help offset the increase in monthly mortgage payments they will have to experience with an increase in interest rates over the current 25- or 30-year period.
- In addition to uninsured mortgages that allow for a longer amortization period, CMHC and other mortgage insurers may also be allowed to increase the maximum amortization period from 25 years to 30, 35 or even 40 years on qualified insured mortgage applications.
The increased amortization rates will help manage monthly mortgage payments and will also allow banks and insurance companies to qualify borrowers based on the increased maximum amortization period. This will allow more borrowers to continue to qualify with an AAA lender instead of having to turn to alternative lenders. One potential problem with this strategy is that it will likely exacerbate the growth of the real estate market and allow property prices to continue to rise, a trend the Canadian government is working to change.
It will be interesting to see how the next year or two play out, but it is my feeling that we will see increased growth in the alternative lending space in the short term, and increased amortization periods down the road.
If you have any questions about mortgage rates or are looking for help with your mortgage, please call 416-674-6222 or email us at info@clovermortgage.ca to speak with one of our professional licences mortgage brokers today.
