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A for sale sign is posted in a housing development in Ottawa in July 2020. The warning about Canada's potential mortgage debt crisis landed the same day that the Canadian Real Estate Association released data home sales and prices rose in April.Sean Kilpatrick/The Canadian Press

Economists at Desjardins Capital Markets have issued a dark warning about how much more damage high interest rates could inflict on the mortgage and housing market: You ain’t see nothin’ yet.

This week, Royce Mendes and Tiago Figueiredo published a report labelling Canada’s mortgage debt “a ticking time bomb.” The detonation time, they argued, is still “a couple of years in the future.”

Their report landed on the same day that the Canadian Real Estate Association released monthly data showing a rise in home sales and prices in April. That news prompted some analysts to suggest that the market had turned a corner, after a year in which sales had plunged nearly 20 per cent and the association’s home price index had sunk more than 12 per cent.

The housing market was in the immediate line of fire in the steep and rapid increase of interest rates that the Bank of Canada began in March, 2022, and put on pause a year later. Now, with the central bank taking some time to assess whether it needs to nudge rates any higher, the focus is turning to next-level consequences of those rate hikes, as the initial effects on the costs of borrowing spread their way more broadly through the overall economy.

But the Desjardins report argues that the pain for mortgage holders has barely started.

The risk lies in what happens when mortgages come up for renewal. Mortgage holders who have renewed in the past year have already been hit with dramatically higher rates – and, thus, big increases in monthly payments. But even bigger hits are yet to come.

The bulk of mortgages taken out during the COVID-19 pandemic, when rates were at their bottom and house prices soared, were for five-year terms. For those loans, renewal crunch time hits in 2025 and 2026. The Desjardins economists forecast that on fixed-rate mortgages, first-time homebuyers (who make up about half of all new mortgages each year) will face 15-per-cent increases in their monthly payments.

The news is much worse for many variable-rate mortgage holders. The interest rate on their loans has gone up along with the Bank of Canada’s policy rate, but in most cases, lenders haven’t increased their payments. Many of these mortgages have fixed payments – the monthly bill remains the same when rates rise, but more of that money is used to pay interest and less to pay principal.

How Bank of Canada interest rate hikes affect variable rate mortgages

About three-quarters of those mortgages have hit their “trigger rate” – when the interest cost exceeds the monthly payment – which would normally mean an automatic payment increase. But many banks are instead leaving monthly payments unchanged, and allowing the excess interest to pile onto the outstanding principal.

It’s a nice break for variable-rate mortgage holders now; but when renewal time arrives, they will not only face a much higher interest rate, but will also have a now-growing pile of debt to service. The Desjardins economists say that some five-year variable mortgage holders could be staring down the barrel of a 40-per-cent payment increase in 2025 and 2026.

The key economic implication is that higher mortgage rates could put their deepest dent in household spending not now, or a few months from now, but two or three years from now. This highly unusual cycle for mortgage costs and home prices will continue to weigh on the economy long after the 18 to 24 months that the Bank of Canada typically considers the horizon for the effects of rate changes. (Note that the Desjardins estimates assume that the central bank will have cut rates to 2.5 per cent, from the current 4.5 per cent, by the end of 2024.)

In an interview Wednesday, Mr. Mendes said there’s a risk that Canada drifts toward a “housing recession,” similar to what we saw in the early 1990s: A sustained slowdown in household spending over several years, as homeowners have no choice but to pour more of their earnings into their mortgages.

“People will be devoting a record amount of their disposable income to servicing their mortgages,” he said. “This is something that has really never happened before.”

And this assumes that the overall economy unfolds as generally predicted by most experts: That we suffer a slowdown, but avert a recession, this year, that growth recovers next year, and that the Bank of Canada begins to cut rates fairly early in 2024.

Things would get more complicated if this soft-landing scenario doesn’t transpire, and the economy falls into a conventional recession – one that includes a significant downturn in employment. Loss of a paycheque would turn these renewed mortgages from merely expensive to unsustainable.

We’ll get a better sense of how concerned the Bank of Canada is about this mortgage landscape on Thursday, when it releases its annual Financial System Review, a detailed assessment of financial-related risks. While the bank’s rate policy is very clearly directed at bringing inflation down to its 2-per-cent target, it will certainly want to keep an eye on how severely those rates will hit households as renewals become a bigger part of the story. The path the bank chooses for rates will play a major role in whether those mortgage risks materialize.

“If interest rates are low enough at the time of renewal in 2025 and 2026, then the extreme challenges can be avoided,” Mr. Mendes said. “The Bank of Canada does have the silver bullet to help solve this.”