Canada’s real estate industry is sounding the alarms on higher rates, warning it’ll “punish” buyers. However, these folks are blissfully unaware that mortgage costs are near record lows. In real terms, households have never had access to mortgages this cheap, which is part of the problem. Central banks distorted credit markets to the point mortgages are free money and leverage for investors. Surprising no one, investors took the cash and inflated home prices to a record high.
Real Mortgage Rates, and How Cheap Credit Drives Prices Higher
Today we’ll be looking at the real rate of a conventional mortgage with a 5-year fixed term in Canada. A real rate is where the cost is adjusted for inflation, which is important to investors. The real return includes the erosion in purchasing power of the money the borrower returns. Negative real returns mean a lender receives less buying power from the money they lent. A negative rate also means borrowers get discounted cash, incentivizing more borrowing.
Why is this important? Because low rates tend to produce capital inefficiency. Rewarding someone for borrowing to buy assets will inflate the cost of those assets fast. That’s part of the reason investors are flocking to housing. How can they not borrow as much as possible to scale their investments this cheap? This generally holds true even with cheap rates, not necessarily negative real ones.
Traditional logic is lower mortgage interest costs make housing more affordable. It’s based on a blunt and isolated model that doesn’t factor in the change in credit demand. Not just for new home buyers, but existing home owners tend to consume more credit as well. This is well documented with the soaring use of home equity line of credit (HELOC) accounts.
Monetary policy’s biggest lever is interest rate adjustments. Central banks lower interest rates to stimulate demand and raise the cost of goods. For some reason, central banks rarely put that together with housing. It’s not that they don’t understand the issue, though.
The BoC states credit raises demand and prices in their new internal forecasting model. More publicly, the central bank mentioned it in a speech. Over the past 30 years, they found lowering interest rates and mortgage costs didn’t make housing more affordable. People adjusted the amount they borrowed and spent it on the same thing. Lowering rates made it easier for sellers to extract more cash from buyers on the sale. Let’s file the past 30-years of trying to improve home prices with lower rates under “whoopsie daisies.”
Just how cheap is mortgage credit now? Borderline absurd, even with rising interest rates.
Canadian Mortgage Rates Are Just Off Record Lows
There’s a lot of noise about rising mortgage costs, but interest is still amongst the lowest in history. A conventional 5-year fixed term mortgage was 3.77% in March, up 0.57 points from last summer’s record low. Mortgage costs are the highest since June 2020, back when dinosaurs roamed the earth. If you can only remember a few months ago, it’s easy to see how rates seem high.
Canadian Conventional Mortgage Rate
The monthly average of interest costs for a conventional 5-year fixed rate mortgage in Canada.
Source: CMHC; Better Dwelling.
The conventional 5-year fixed-term mortgage has rarely been this cheap in Canada. Prior to 2020, only a briThe conventional 5-year fixed-term mortgage has rarely been this cheap in Canada. Prior to 2020, only a brief period between 2015 and 2017 were mortgage rates this low. That was during the Greater Toronto and Vancouver mini bubble. Before 2015, a mortgage this cheap was virtually unheard of since free markets have a cost attached to capital. Generally investors don’t like to lend money out to other investors for a loss. Only the government is that dumb.
Real Mortgage Rates Have Never Been This Low
Real mortgage rates highlight how inefficient credit costs are in Canada these days. Headline inflation for March showed annual growth of 6.7%, the highest in the past 31-years. That makes the real mortgage rate -2.9% for the same month, a decline of 4 points since last year. The last time real mortgage rates were negative was in the 70s leading up to the inflation crisis. It’s never been this low, though.
Canadian Real Mortgage Rates
The inflation adjusted rate of interest on a conventional 5-year fixed rate mortgage in Canada.
Source: CMHC; Statistics Canada; Better Dwelling.
Canada’s overly cheap mortgage debt has created all kinds of inefficiencies. When money is this cheap, and lenders are taking a real loss, there’s going to be excess demand. This is fairly obvious when looking at the share of investors in Canada’s real estate market. Money is decaying at over 3x the desired rate, so of course they’re buying homes. The share of investors even outpaces first-time buyers, since they have more leverage.
Mortgages aren’t just free, but borrowers get to take a massive discount on the funds in real terms. It’s the kind of inefficiency the free market couldn’t produce. Central bank intervention, and then neglect, are to blame. As this inefficiency reverses, credit demand will moderate to more normalized demand.