Mortgage Interest Rates in the COVID-19 Economy

Mortgages and interest rates are still talked-about topics in the current economic climate.

Here’s a recap. In January 2020, just prior to the pandemic surfacing in Canada, a five-year fixed rate was trending at approximately 2.89% to 3.09%. Fixed mortgage rates are loosely based on bond yields, which were trading at 1.5%.

The Bank of Canada’s (BoC) overnight rate, or key lending rate was 1.75% and the prime lending rate was 3.95%. Variable mortgage rates and lines of credit are based on the prime rate. At the time, mortgage lenders were offering discounted prime rates for new deals – some as high as 1%.

By March 2020, 5-year bond yields fell as low as 35 basis points and fixed-rate mortgage rates also fell to as low as 2.39%, but then went up to about 2.84 to 2.99%%, but are now starting to trend downwards again.

Also, in March, The BoC, cut its overnight rate three times - - it now sits as .25%. Most lenders also lowered their prime lending rates to 2.45%; however, the deep discounts have disappeared. Variable-rates are sitting at approximately Prime minus 20 basis points, or 2.25%.

It's commonly thought that five-year fixed mortgage rates are connected to five-year bond yields and that cuts to the BoC’s overnight rate will result in lower fixed rates. The two are not actually connected. Similarly, variable-rate mortgages were thought to be connected to the BoC’s overnight rate, and historically this has been the case, but it’s not written in stone.

In the current economic environment, the “traditional” rules are out the window, simply because what the economy is going through is unprecedented and everyone is moving cautiously.

Despite low bond yields and cuts to the prime rate, lenders are considering other factors – the rise in unemployment for one. One of the main indicators pointing to a continued healthy economy is jobs. Without jobs, household budgets get tighter, consumer purchases slow down, manufacturers scramble to reduce inventory, which could lead to lay-offs, and bankruptcies rise. Job loss is also a leading cause of mortgage default.

Statistics Canada reported that the country lost one million jobs in March, but that’s only a glimpse since the data is based on surveys in the week that started March 15. For perspective, economists suggest Canada's unemployment rate right now is likely around 20%, from an “average” of 5%. As you can see, the economic situation has been volatile and conditions can change daily.

Because the outlook is uncertain, and future mortgage defaults may be higher, lenders built risk premiums into their rates and we saw mortgage rates increase, despite the signs that borrowing costs were reduced.

The Government is keeping the economy afloat by injecting billions of dollars of financial support into the economy and, by default, instilling a small degree of confidence in Canadians. However, it’s likely that Canada will be in a recession – as some economist say it is now, and will take many months to recover.

The housing market is a vital component to the success of the Canadian economy. In many respects, the industry can help to stabilize a faltering economy.  Having said that, not everyone is out of work and consumers are still buying and selling houses.

There is an end game here and eventually the economy will start humming along. Jobs will return slowly, and low interest rates will likely be around for a while as we start the hard road to recovery.

Interest rate increase has winners

Believe it or not, the recent .25% rise in the prime interest rate is an indicator of a healthy economy. Despite trade tensions, Canada’s economy looks to be weathering the tariff storm well, for now.

There is no doubt the Canadian economy is resilient. The country has weathered a few storms since 2008, but still chugs on – somewhat flat at times, but never stagnant. The focus of the Bank of Canada (BoC) is on stimulating the economy and keeping inflation in check. The inflation rate has been inching up and is now at 2.2%, still well within the Bank’s comfort zone. Maintaining low, stable and predictable inflation is key to fostering an environment where Canadians can prosper. 

There are many factors that contribute to rising interest rates. Since the economy has been in recovery mode for a while, it now makes sense the BoC would start raising the rate, given a few economic indicators.

One of the main indicators that point to a continued healthy economy is the job numbers. Without jobs, household budgets get tighter, consumer purchases slow down, manufacturers scramble to reduce inventory, which could lead to lay-offs, and bankruptcies rise. And job loss is also the leading cause of mortgage default.

In June, the economy added 31,800 positions. At the same time the unemployment rate rose to 6%, from 5.8% in May. The higher jobless rate is considered a good sign by analysts who see it as more people optimistic about finding a job.  Average hourly wage growth has maintained the same level as last month at 3.6%. 

What we don’t know is the effect of NAFTA negotiations and how an extended trade war will affect the economy. What we do know is how the recent increase will impact Canadians in the short term. 

First, the cost of borrowing will increase for customers with variable-rate loans and mortgages, but those with money in savings accounts and guaranteed investment certificates will benefit. When interest rates are low, there’s less motivation to save. 

The rate hike may also make Canadians think twice before adding to their debt loads. Canadians are carrying a record amount of debt -- $1.8 trillion and growing -- because of low interest rates. Hopefully, as rates rise, consumers will reconsider adding to their debt loads.

Seniors and retirees also benefit from rising rates. Seniors now have the opportunity to generate higher interest income, which may help them manage rising costs.

With people living longer, those with pension plans are in a better financial position against running out of money. 

The housing market is cooling a bit because of the new rules introduced this year, which may help affordability for future homeowners as the pressure to bring prices down grows. We are not seeing this happen yet in strong urban markets like Toronto and Vancouver.

There’s a fine line between interest rates that are too high or too low and how they may help one segment of our population and hurt another. 

While we have no control over interest rates, we do have control over our responses by thinking more carefully about our finances – our savings and our borrowing – so we’re not caught in challenging situations, no matter what the rates do.

Housing affordability continues to erode

New mortgage rules, rising interest rates, and stress tests have definitely cooled housing market activity by making it more challenging for some to qualify for mortgage. An unwelcome consequence continues to be eroding affordability -- as sales activity slows down, house prices have continued to go up, and not only in major urban centres. 

In the first quarter of 2018, home affordability eroded further at the national level – the 11th straight quarter of declines, according to a report by the National Bank. The bank measures affordability as the mortgage payment on a median-priced home as a percentage of median income. Last quarter, the metric rose by 1.2 points in Canada. The higher the metric, the worse the housing affordability.

The bank also suggests that as interest rates rise, affordability will continue to decline, setting the stage where prices have nowhere to go but down. But when? And will it be too late?

The National Bank report also says that by the end of 2019, prices would need to fall 2% in Toronto and Vancouver to keep home affordability from eroding further.

Economists have been predicting a more stable, balanced economy where people are happily working and are able to pay their debts; where interest rates are “low normal” and where house prices are affordable.  Well, that was a few years ago. The once booming real estate sector is in a bit of a slump. 

The Canadian Real Estate Association (CREA) reported that national home sales on the MLS were down 2.9% in April 2018, to the lowest level in more than five years. About 60% of all local housing markets reported fewer sales.

According to Will Dunning, Chief Economist, Mortgage Professionals Canada, data for the first quarter of 2018 points to a sharp slowdown. For the first quarter, the sales rate was 10.3% slower than in 2017. The average price in Canada was $482,782– a 4.8% drop compared to a year ago. However, when we look at the price index as opposed to averages, which can be easily skewed, Dunning reports a different picture.

The index from CREA shows that in the first quarter of 2018 prices were 6.4% higher compared to a year ago. The index from Teranet/National Bank shows a rise of 7.6%. Price growth is strongly influenced by the balance between supply and demand, which can be measured using the sales-to-new-listings ratio. The data from CREA indicates that the ratio was 56.6% in the first quarter. Based on that ratio, Dunning expects house price growth in many areas of Canada, which is what is indeed happening.

We are living in strange times. World economies have changed; NAFTA is at risk and our economy might start to feel the effects of a trade war with the US. The new mortgage-insurance rules and stress test have indeed impacted the market, especially for the first-time homebuyers.

In an April 2018 survey by West Coast Capital Savings, 60% of young British Columbians (18 to 29 years old) believe it’s impossible to buy a house in the province’s pricey real estate market and are “seriously considering” moving to areas where home ownership is less costly.

While some homebuyers can adjust their housing expectations and move to buy something less expensive, some potential buyers will be knocked out of the market. And will there be enough, good inventory available for purchase?

There is no arguing that the market has cooled, but it has not stopped. We have not yet heard of massive foreclosures, which mean that households continue to pay their mortgages and their debts. 

So, the big question is when will prices really start coming down in a way that will make housing affordable again. 

We need to continue to closely watch the market to determine if rising rates and lower home values are a blip or a trend which will ultimately impact long term affordability for Canadians.

How to prepare for rising interest rates

Over the past few years it seemed every expert was telling us that interest rates would be rising, and now after years of record low rates, the Bank of Canada (BoC) has started to raise them. The first increase was in July, the first in seven years from 0.5 per cent to 0.75 per cent, citing “bolstered” confidence that the Canadian economy has emerged from years of slow growth.

Canada’s largest banks matched the central bank’s move by raising their prime rates by a quarter-percentage-point to 2.95 per cent. Prime rates influence the cost of borrowing on floating-rate loans, including variable-rate mortgages, credit lines and student loans. It’s expected the BoC may continue to raise the prime rate incrementally over the next few months and into 2018.  However, economic conditions change and so do outlooks and forecasts.

Fixed-rate mortgages are tied to bond prices and yields and currently they are fairly flat. There is some talk about the impact of risk-sharing going forward in the mortgage market, but for now, all quiet of that front.

So, here we at a crossroads again when getting a mortgage. Do you take the fixed rate or the variable rate? And once again, the answer is – it depends.

Many home buyers choose a fixed rate because they know exactly how much principal and interest they pay on each regular mortgage payment throughout the term. However, when interest rates go down, they can’t take advantage of that to save money on interest.

Variable rates continue to be popular among home buyers, with fixed rates gaining favour because they continue to be relatively low. At this writing, a five-year fixed rate varies from 2.89% to 3.09% while a variable rate ranges from 2.2% to 2.6%.

A study of mortgage data from 1950 to 2007 found that by choosing a variable rate mortgage, Canadians saved $20,000 in interest payments over 15 years, based on a $100,000 mortgage. At that time, homeowners were better off with a variable rate mortgage than a fixed rate mortgage 89% of the time.

In today’s market variable and fixed rates do not look as if they’ll be dropping.  It is possible that rising interest rates are here to stay, but it’s important to ask the question: Is it just a blip or a trend?  Time will tell.

In the meantime, it might be prudent to prepare for rate increases this year and through 2018.  Here are some suggestions:

• Lock in your mortgage.  When prime rates start rise, variable-rate mortgage holders may be vulnerable. This is a personal decision and is based on your risk tolerance. At minimum, consult your mortgage broker to find out what works best for you.
• Don’t commit to long-term GICs. It doesn’t make sense to tie up your money for five years in an environment where rates are likely to rise.  Speak to your investment counsellor.
•  Stay short-term with bonds. When rates rise, bond prices go down. That doesn’t mean stay away from bonds, just invest in the short-term. Again, speak to your investment counsellor.

We have been in an historically-low interest rate environment for eight years now -- it looks as if it may change.