One of the world’s largest economies is handcuffed to over-leveraged home buyers. An analysis from Oxford Economics looks at two rate hike scenarios in Canada. Tony Stillo, the firm’s chief economist, expects the Bank of Canada (BoC) to hike interest rates slowly. If the central bank takes this path, all households will bear the burden of higher inflation. However, mortgage repayment would see a minimal increase. If the central bank pursues a more aggressive schedule to fight inflation, households feel a bigger pinch.
Canadian Households Owe $2.5 Trillion In Debt
Canadian households have loaded up on mortgage debt during the pandemic. Total household debt reached $2.5 trillion in Q3 2021, driven by $193 billion in mortgage debt since Q4 2019. Mortgage debt represents 68.7% of household debt in Canada, up 4 points over the same period. Households accelerated their mortgage debt through the pandemic. It might cost them a lot more than they anticipate in just a few months.
BoC Forecast To Hike Rates Slowly, Embrace High Inflation
Oxford Economics has forecast one of the least aggressive rate hike schedules. They see the current 0.25% rate holding until Q4 2022 and rising gradually to the “neutral” level of 2% by mid-2026. That’s a very slow increase and unlikely to resolve inflation issues.
The firm sees the BoC embracing higher inflation to ensure the comfort of debt holders. Which would be swell, no? If you didn’t borrow as much as you could, your reward is seeing your purchasing power fall. In a way, households would be subsidizing indebted households to make payments more manageable.
Stillo estimates a very manageable increase to the average payment in this scenario. They estimate the debt service ratio (DSR) would increase from 6.3% in Q3 2021 to 8.2% in Q4 2023. It would be the same level of burden seen in 2018-2019 when the BoC last hiked rates.
The firm estimates the average mortgage payment would rise $86 in Q4 2023 and $236 in Q4 2026. Not exactly earth-shattering, but not insignificant. If a median 30-year old diverted this cash from their retirement planning, it would produce a $200k shortfall by the age of 65. Small changes can have a material impact. That’s the reason people lend money, though.
If The BoC Hikes To Curb Inflation, Indebted Households Will Pay A Lot More
Canadian households are in for much higher debt payments if the BoC tries to fight inflation. They forecast the central bank would begin hiking rates early next year in this scenario. Interest rates would hit the neutral 2% by mid-2023, more than three years earlier than in the ideal scenario. The more aggressive schedule is more in line with financial institution forecasts.
Aggressive hikes to curb inflation would lead to a sharp increase in the debt burden. Households would see their DSR rise above the 2018-2019 peaks during the last rate hikes in Q4 2022. By Q4 2026, we could see the DSR hit 10% — matching the pre-Global Financial Crisis high. The average mortgage would rise $166 by late 2023 and “…strain household finances.”
When most people hear “strain household finances,” they think mortgage defaults. All hell breaks loose, and the world ends. That’s not the case. These highly indebted households would most likely just reduce their consumption.
Reduced consumption sounds terrible until you realize it happens in either scenario. If indebted households don’t reduce consumption due to higher rates, inflation stays elevated. If inflation is elevated, everyone reduces consumption as buying power shrinks. Extend low rates to save highly indebted households, or save the whole population from taking a hit? Tough one, I know.
Inflation being a widespread issue is why institutions are betting on hiking soon. National Bank of Canada (NBC) said the recovery would be in jeopardy if rates don’t rise next quarter. Scotiabank has also forecast eight rate hikes over the next two years. That’s similar to Stillo’s aggressive scenario. In any case, it might be time to redraw that budget if you’ve been on a mortgage debt binge recently.