Welcome to Mortgage Rundown, a quick take on Canada’s home financing landscape from mortgage strategist Robert McLister.
The Bank of Canada is fighting inflation – by inflating your borrowing costs.
Its supersized 50-basis-point move on Wednesday is the second dose of rate reality it’s administered since March 2.
But more importantly, and subtly, the bank boosted its projected “neutral” rate by 25 bps. Its midpoint estimate for neutral – the theoretical rate that supports stable inflation – is now 2.5 per cent. The implication is that rates need to climb another 150 bps, or more, to get inflation on track long-term. (There are 100 basis points, or bps, in a percentage point.)
If you’re one of the few million floating-rate borrowers out there, you’re undoubtedly wondering when this all ends.
Tiff Macklem, Governor of the Bank of Canada, told reporters on Wednesday that “Canadians should expect interest rates to continue to rise” to approximately 2 to 3 per cent, its estimated neutral rate range.
But bank estimates, like any professional forecast, tend to be a little off. Recall, for example, Mr. Macklem’s comment in July, 2020: “Our message to Canadians is that interest rates are very low and they’re going to be there for a long time.”
So there’s a chance the overnight rate doesn’t make it to 2 per cent. Just don’t bet on it.
In fact, the opposite is more likely, with the bank warning of an “increasing risk that expectations of elevated inflation could become entrenched.”
Mr. Macklem also reminded mortgagors on Wednesday that he could “take rates modestly above neutral for a period ….” If your finances are a little shaky, believe him this time and plan for that possibility.
History shows what’s possible
The overnight rate guides prime rate, which in turn is the basis for variable mortgages.
If you look back to the 1930s – the furthest back that Bank of Canada prime rate figures go – there have been 14 meaningful rate-increase cycles where prime rate rose one percentage point or more.
During those cycles, prime rate increased about 60 per cent on average. In today’s terms, that would be like prime rate climbing from 2.45 per cent, where it started this rate hike cycle, to about 3.95 per cent.
With today’s CPI inflation nearly three times normal, that’s the least increase one should expect.
The mother of all rate moves occurred from March, 1978, to August, 1981, when prime rate catapulted 176 per cent. In today’s terms, that would be like prime rate hitting 6.75 per cent, more than 350 basis points above today. Sheer devastation for mortgagors.
More likely is that the overnight rate hits the high end of the bank’s neutral range, carrying prime rate to little more than 5.2 per cent. That’s a distinct possibility with Canadian’s 12-month inflation expectations running at almost 7 per cent, according to a Morning Consult survey. (Those expectations are further above the 2 per cent inflation target than any time in history.)
Okay, so fixed or variable?
Google Trends shows a record number of Canadians searching for advice on whether to get a fixed or variable rate. But for savvy mortgagors, the market will soon make the choice for them.
Normally, demand for fixed rates grows as interest rates increase. But smart borrowers know that rates are cyclical. Variable rates virtually always outperform when prime rate shoots above its five-year average.
Assuming the Bank of Canada takes rates back up to “neutral,” which could happen within the next 12 months, the bond market will anticipate an economic slowdown. It’s then only a matter of months or quarters until bond yields fall, fixed rates fall and eventually the overnight rate falls. Those down cycles are when floating rates shine.
Impact on mortgage stress test
Wednesday’s hike by the Bank of Canada will have little impact on mortgage applicants getting approved. After a few more rate hikes, however, this will change.
Once prime rate hits 3.95 per cent, which bond derivatives imply will happen by July 13, almost all new borrowers will be stress tested at rates exceeding today’s 5.25 per cent minimum stress test rate.
From that point on, the real estate party dies down somewhat. Fewer people qualify for a mortgage and home buying slows more noticeably.
The latest stress test trick
Given how the mortgage stress test works, prime borrowers who get a variable or one-year or two-year fixed mortgage today only have to prove they can afford a rate of 5.25 per cent.
It’s a different story for borrowers who use federally regulated lenders and want a five-year fixed. They’re currently stress tested at rates near 6 per cent. Qualifying rates haven’t been that high since before the credit crisis.
“For sure, people are using variable rates to qualify,” says John Webster, chief executive officer of Scotia Mortgage Corp. “That’s a result of government action. They came up with the qualifying rate.”
As a result, lenders are seeing some would-be five-year fixed borrowers choose variable rates, only to immediately lock into a fixed rate after their mortgage closes, Mr. Webster says. That’s because banks don’t have to stress test you when you convert from variable to fixed.
Elsewhere in mortgage rates
Wednesday’s 50-bps hike by the Bank of Canada lifts the average nationally advertised uninsured variable rate from 2.15 per cent to 2.65 per cent. That’s still 124 bps below average five-year fixed rates.
And speaking of five-year fixed rates, a few months ago people were getting five-year fixed pre-approvals in the upper 2-per cent range. Those rate holds run out in the next 60 days. Buyers who let those “free options” expire will face market rates that are 100 bps higher.
Rates in the accompanying table are as of Wednesday from providers that advertise rates online and lend in at least nine provinces. Insured rates apply to those buying with less than a 20 per cent down payment, or those switching a pre-existing insured mortgage to a new lender. Uninsured rates apply to refinances and purchases over $1-million and may include applicable lender rate premiums. For providers whose rates vary by province, their highest rate is shown.
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