Discount mortgages dry up as Canadian borrowers face tough test

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The discount mortgages that stoked the Canadian housing boom are disappearing, increasing the likelihood of a correction in home values.

On Thursday, Royal Bank of Canada will hike its five-year fixed-rate mortgage to 3.89 per cent, one day after the Bank of Montreal raised its rate to 3.79 per cent. The other major lenders are all moving in the same direction.

The increases mean the cost of a new fixed-rate mortgage has climbed by more than a third in five months, signalling what could be the beginning of the end of ultra-cheap credit in Canada – and the start of fiscal pain for consumers who have overburdened themselves with debt.

"I think this is the real thing," said Benjamin Tal, deputy chief economist at CIBC World Markets. "This is the end of extremely low interest rates. They're simply unsustainable."

So far, interest rates on other kinds of consumer debt are not on the rise, since they are often tied to the Bank of Canada's benchmark rate, still sitting near a record low. Even so, the rise in mortgage rates will strain the ability of borrowers to juggle their debts.

"This is the beginning of a test for the mortgage market," Mr. Tal said. "It's a test of how Canadians are able to tolerate higher interest rates."

And it is a test that came on swiftly and unexpectedly. Just five months ago, Finance Minister Jim Flaherty publicly scolded both BMO and Manulife Financial for offering mortgages he deemed irresponsibly cheap, advising against a "race to the bottom," as mortgage rates sank as low as 2.89 per cent.

While the inevitable climb of mortgage rates has had false starts over the past couple of years, the recent hikes could be the first phase of a long-term trend.

"They're going up every time we turn around," said Paula Roberts, a Toronto mortgage broker. "It's a shock to clients. Everybody just thinks they're always going to stay low."

As developing economies such as China falter, the United States has re-emerged as the likely engine of global economic growth. The improving U.S. outlook is already pushing up some lending rates, and should eventually reduce the need for central banks in the United States and Canada to hold down short-term interest rates to spur the economy. As long as the United States is making progress, mortgages here will probably continue to get more expensive.

The Canadian housing market is also still recoiling from regulatory changes Mr. Flaherty imposed in recent years in a deliberate attempt to engineer a "soft landing" for overpriced residential real estate. Last year, he reduced the maximum amortization period for a government-insured mortgage to 25 years from 30 years.

Speaking with reporters Wednesday outside a policy retreat in Wakefield, Que., Mr. Flaherty indicated that he sees no need at the moment for further intervention. "There are some bumps along the road in Toronto and Vancouver, in particular in the condo markets, but overall, I'm satisfied that the measures we've taken over the last several years have adequately calmed the markets."

With multiple forces colluding on raising Canadian mortgage rates, the stubbornly strong housing market could finally relent. "Buying the same house will be more expensive this fall than this spring," said Peter Routledge, an analyst at National Bank Financial.

An expected rise in rates could spur some to buy homes immediately to avoid the increased costs. Other prospective buyers will find they can no longer afford home ownership. "It's going to limit the people that can buy," Ms. Roberts said. "And it's going to take longer for people to get into the market."

Demand for homes could fall as a result. After that, the magnitude of the market's reaction is difficult to anticipate. "Housing markets are prone to overreaction in both ways, the upside and the downside," Mr. Routledge said. "The possibility that you get a vicious cycle goes up as rates go up."

With a report from Bill Curry

Clarification: An earlier version of this story said the improving U.S. outlook has removed the need for central banks in the United States and Canada to hold down interest rates to spur the economy. In fact, the improving U.S. outlook is pushing up some lending rates, and should eventually reduce the need for central banks in the United States and Canada to hold down short-term interest rates.