Debt-laden homeowners face threat of rising interest rates

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An economic growth spurt is bringing the prospect of higher mortgage rates at a time when many Canadians in the country's largest cities are stretching to afford homes.

Some analysts expect the Bank of Canada will raise the rate it charges financial institutions to borrow money overnight this fall after the central bank's No. 2 executive gave an upbeat assessment of the economy, saying growth has returned to most industries and regions. An increase in the overnight rate would immediately raise the cost of variable-rate mortgages and home-equity lines of credit.

Fixed-rate mortgages could rise even sooner. They are influenced by rates in the government bond market, which have soared in recent days. One of the most popular kinds of mortgages, a five-year fixed-rate loan, takes its cue from the yield on the five-year Government of Canada bond, which jumped to 1.15 per cent late on Tuesday from 0.92 per cent a week ago. That is a large enough increase to start putting pressure on lenders to raise mortgage rates.

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The increasing likelihood of higher borrowing costs comes at a precarious time . Canadians have record debt levels, largely due to borrowing to pay escalating home prices in major cities, particularly Vancouver and Toronto. Many homeowners are already scrambling to make payments.

Canada Mortgage and Housing Corp. reported on Tuesday that the average scheduled monthly mortgage payment for new loans was $1,328 in the final three months of last year, an increase of 4.6 per cent from $1,269 in the same period in 2015. Households have been loading up on debt even as income growth stagnates.

The Bank of Canada has started to prepare the country for higher borrowing costs in the months ahead. After bullish comments on Monday from senior deputy Governor Carolyn Wilkins, economists and investors began moving up their estimates of when the central bank will increase rates for the first time since 2010.

"We believe it will be earlier than what the market is expecting," said Benjamin Tal, deputy chief economist with CIBC World Markets Inc. "It's more likely that you'll see the Bank of Canada moving as early as October."

Rates for longer-term fixed mortgages have already begun ticking upwards, said Robert McLister, founder of RateSpy.com, a mortgage-rate comparison website. However, the increases have been small so far, between 10 and 15 basis points. (A basis point is 1/100th of a percentage point.) It would take a larger increase than that to have a major impact on the real estate market.

"You need to see 150 to 200 basis points movement before you get a significant shakeup in the housing market, with people foreclosing," Mr. McLister said.

Despite the recent surge in five-year bond yields, Mr. Tal said he expects mortgage rates will rise only gradually over the mid- to long term. They would be going up from extraordinarily low levels: Toronto-Dominion Bank, one of Canada's largest mortgage providers, is currently advertising a four-year fixed mortgage at less than 2.5 per cent.

Still, with debt levels already high, the Bank of Canada will have to tread carefully, Mr. Tal said.

"The history of recessions in the postwar era is the history of overshooting," he said. "Namely, central banks sit on very low interest rates for a long period of time, they wait and wait, and then they start raising very quickly because inflation is sneaking up on them. And when you raise quickly, you shock the market. …

"The issue with the housing market in Canada is not really higher rates, it's rapidly rising rates," he said, adding that he expects the Bank of Canada to take a gradual approach to rate increases. "You start early, you move by 25 basis points. I think that would be desirable."

Mortgage default rates are currently very low, but that could change if interest rates shoot higher. More subtle risks to the economy include a pullback in the consumer spending that has sustained growth in recent years. People may also have less money to save, which suggests a shortfall in retirement savings in the decades to come.

Even a modest increase in rates can have a big impact on finances in households that have large mortgages. At the national average house price of $559,317 in April, an increase in mortgage rates of 0.5 of a percentage point from today's levels would boost monthly mortgage costs by $130 a month. This assumes a 10-per-cent down payment, a 25-year amortization and a starting mortgage rate of 2.5 per cent.

A decline in house prices caused by rising rates could cause further damage to household balance sheets. Rising prices have given home owners equity that they can tap into to refinance other debts and pay for big expenses such as home renovations. Falling home values would cut this off.