What's the Scoop With Interest Rates? A Mortgage Breakdown
It’s no secret that Canadian interest rates are low. The prime rate for Canadian mortgages, which is influenced heavily by the policy interest rate (target overnight rate) set by the Bank of Canada (BoC), currently sits at 2.45%. If anything, 2021 offered a perfect landscape to analyze in real estate. With interest rates at their floor stress tests were implemented, policies were suggested, and a federal election took place.
Gears are in motion and plans have been set, but what does 2022 have in store when it comes to interest rates and mortgages? Let’s look more closely at prime rates and what the Bank of Canada has in store for homeowners.
The relationship between prime rates and the Bank of Canada overnight rate
Anyone who borrows money is affected by the prime rate, and interest rates in housing are based off if the prime rate goes up or down. For example, each bank or lender determines their own prime rate. However, Canadian banks often use the BoC target overnight rate as a barometer. Any shifts in the target overnight rate influence similar changes in prime rates.
Therefore, many Canadian banks and lenders have similar prime rates. Look at the graph below to see how BoC overnight rates and prime rates function together.
Prime rate and Bank of Canada overnight rate (1935-2022)1
Following the steady decline of the BoC overnight rate, you can see that the prime rate is the lowest it’s been in close to a century. Over 2021, this opened the door to a wave of prospective home buyers and investors. According to the Canadian Real Estate Association (CREA), annual home sales reached a new high in 2021. The year surpassed the previous record by around 20%, with 667,000 residential properties sold.2 The decreased cost of financing clearly had an impact on the amount of activity we saw in the Canadian real estate market.
In fact, this upward movement was in the face of a June stress test designed to slow the hordes of Canadians and investors securing mortgages at the floor prime rate. The stress test meant uninsured borrowers faced an increased mortgage qualifying rate to ensure that they can handle their payments if rates go up. Borrowers had to be able to carry payments at the contracted mortgage rate plus 2%, or at an interest rate of 5.25% – whichever is higher.
After political promises and a proposed ban on “blind bidding,”3 many are wondering what 2022 has in store for Canadians.
Let’s look at what experts expect the Bank of Canada to adjust in 2022.
What are the predicted changes for 2022?
Experts predicted that the BoC’s target overnight rate will increase from 0.25% to 0.5% in 2022.4 It’s important to note that the target overnight rate has not been altered by the BoC in almost two years. However, inflation is at 4.7% in Canada. More specifically, home and mortgage insurance costs increased 9.3% in December 2021.5 Therefore, it is predicted widely across the industry that the BoC won’t wait any longer to adjust the overnight rate.
In October 2021, Bank of Canada Governor Tiff Macklem suggested that the Bank of Canada could increase rates “in the middle quarters of 2022.”6 If the BoC’s overnight rate goes up, the interest Canadians pay on debts will increase as well. An increase in the key interest rate could happen as early as April 2022, and the BoC updated its stance on this on January 26th, 2022.
In late January, the bank held its target for the overnight rate at the effective lower bound of 0.25%, with the bank rate at 0.5% and the deposit rate at 0.25%. The release stated, “with overall economic slack now absorbed, the Bank has removed its exceptional forward guidance on its policy interest rate. The Bank is continuing its reinvestment phase, keeping its overall holdings of Government of Canada bonds constant.”7
Long story short? No rate spikes just yet.
How do the Bank of Canada changes affect homeowners, buyers, and sellers?
The cost to acquire a home can be affected by interest rate increases as purchasing power for first-time buyers is impacted. In addition, owning a home will be more expensive and it will be more difficult for Canadians to be approved for a mortgage, especially those with financial concerns.
Some expect that a higher lending rate will cool the market. And in theory, it should, given that the flurry of demand was caused by buyers taking advantage of the lower cost of owning a home. Tight conditions across the country did not aid in this search. For the opposite to occur, that is, a higher interest rate driving increased activity in the market, we would have to see unlikely scenarios take place. It is not unseen, but we expect the market to adjust more traditionally to BoC changes. The rising inflation over 2021 is a problem, as it makes borrowing money for car loans, student loans, credit cards, and mortgages more expensive.
Those who are locked into fixed mortgage rates, do not have to worry about increased costs during the term of their mortgage. However, when the time comes to renew, they might have to negotiate and agree to a higher rate. Simply put, a higher interest rate on a mortgage means less of what a homeowner puts down is going towards their principal loan. Variable-rate mortgage owners would see an immediate effect on their mortgage payment, with more money going to interest and less to the principal.
Prospective buyers in the market could potentially feel the effects of a higher mortgage interest rate. Especially those looking to buy in pricey markets like Toronto or other regions in the GTA. A slight increase of 1% could mean homeowners pay thousands more in interest over the span of their mortgage.
If 2021 taught us anything about interest rates and mortgages, it is that a “good thing” cannot last forever. And the only reason we put “good thing” in quotations, is because while low-interest rates allow for greater accessibility and affordability, they are not always what is needed for a sustainable market. Especially when large fish and foreign investors have the capital to take advantage of the landscape at a much higher capacity than the average citizen. Many Canadians signed up for the decreased costs of owning a home without estimating if they would be able to afford the costs once the inevitable interest rate spikes arrived. We will see the effects of this in 2022.
All in all, the hope is that the increases come at a moderate pace. This will allow Canadians who purchased a home during the pandemic to carefully plan for the increased costs, while slowly creating more restrictions and barriers to entry for foreign investment and real estate funds.
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