After decades of telling the public that low rates make housing affordable, Canada’s central bank is declaring, whoops! Bank of Canada (BoC) research shows decades of low rates did not make housing affordable. In fact, it had the opposite effect — increasing the size of mortgage debt. Real estate markets absorbed the increased debt capacity as households began borrowing more.
Mortgage Debt Service Ratio (DSR)
Let’s start from the top for the folks that need a quick refresher on debt terms. A mortgage debt service ratio (DSR) is the share of disposable incomes spent paying a mortgage. When the mortgage DSR falls, less income is dedicated to paying mortgage debt. If the ratio rises, the share of income going to debt repayment grows.
There’s a couple of issues that rising mortgage DSR levels can create. Beyond affordability, every point spent servicing debt is capital diverted from other areas. Fewer dollars spent in the general economy means slower growth and smaller investments. While expensive housing is a great way to produce short-term wealth, it becomes a long-term liability.
The other issue is mortgage DSR numbers seem small. We always receive an email after publishing the data from the industry. It usually reads something along the lines of, “it’s single digits! That’s not high at all! Everyone can pay that, easy!”
True, it would be easy to pay a single digit DSR. However, this is an aggregate number, for the whole population. People who own their home outright and renters drag down the average. So do people with $600/month mortgages on homes they bought 20 years ago.
When looking at a national mortgage DSR, you’re not looking at how it impacts a single household. You’re looking at how it impacts the country, and how it’s changing. For the mortgage DSR to change rapidly, means people are borrowing a lot faster. Just the small pool of recent buyers needs to borrow so much, it skews a whole national trend.
Canadian Mortgage DSRs Have Been Rising Over The Past 20 Years
Since 2000, Canadian mortgage rates have declined dramatically along with interest rates. The BOC estimates the average rate for a 5-year fixed rate insured mortgage has gone from ~8% in 1990 to ~2% in Q2 2021. The cost of borrowing dropped by ~75%, which in theory should have made it much more affordable to buy a home. Except your average Millennial can tell you that’s not what happened.
Like the Christopher Columbus of real estate, the BoC has discovered housing is more expensive. The mortgage DSR went from 5.39% in 1990 to 6.51% in Q2 2021. Golly gee whiz, that’s more than a point higher.
Canadians Borrow More Debt When Rates Fall
Canada’s central bank has found people borrow more when rates are cut. As we discussed recently, the ratio of mortgage debt to gross domestic product (GDP) was 38.0% in 2000. In Q2 2021, it reached 71% — mortgage debt grew at nearly twice the speed of the economy.
What does this mean? It’s hard to word it more elegantly than the BoC did: “… when interest rates fall, many households simply adjust by borrowing more.”
The Myth of Falling Rates Improving Housing Affordability
The common mantra repeated is that lowering interest rates improves affordability. At a high level, this makes sense — lower interest costs make it more affordable to carry debt. The catch has always been as long as the size of that debt stays a similar size or smaller.
The rate cuts only helped a limited number of existing homeowners though. One would have to be renewing their mortgage to actually save money in this scenario. If you aren’t renewing, you might save a little money if rates are still lower a few years down the road.
Once again, those savings only occur if your debt levels stay the same or shrink. In reality, a significant number of households withdraw equity upon refinancing, which adds up to billions of additional debt. Then there’s the home equity line of credit (HELOC) drawn. All of this makes sense, since low rates are meant to entice borrowers to help credit grow. The improved affordability narrative was just slapped on.
The cheap mortgage debt also increases the amount of leverage a household can carry. How do you think this impacts home buyers in a tight market? That’s right. Sellers absorb the increased debt capacity, ultimately leading to higher home prices.
Household budgets act as friction for home prices, slowing down growth. It doesn’t matter if you say a home is worth $1,000,000, if the only qualified home buyer only has $900,000. The seller either has to accept the qualified buyer’s price, or not sell their home. You can’t get blood from a stone.
Lowering rates expands budgets, allowing households to borrow more money without higher income. After decades, with interest rates near zero, budgets expanded faster than wages. Tight markets just absorbed this increase in home prices.
Low Rates Exacerbate A Shortage of Inventory
Low rates also tend to produce a shortage of inventory as well. By increasing budgets, a cohort of homebuyers is pulled forward. This creates a double cohort — since they‘re now competing with existing buyers. If the demand rises above historic norms, it’s said the rate cut produced excess demand for homes. BMO estimates excess demand over the last year reached 6% of GDP — an astronomical number. That’s just excess home sales above trend, due to monetary policy.
New listings of inventory have only dropped minimally, but that’s not how it feels to buyers. Supply doesn’t grow as fast as credit, leading to normal-ish inventory feeling tight. Even with almost no population growth.
Then there is the whole issue where low rates attract investors. Low rates lower bond yields, where investors traditionally look for fixed income. By driving their returns below inflation, this diverts investor capital into alternative assets. Housing being an alternative asset, for those that need a spoiler.
The BoC is going through a renaissance, discovering aspects of behavioral finance. This month it’s: low rates didn’t improve affordability. A few months ago: easy credit leads to higher home prices. Whether they’re willing to use any of this information to create stronger policy is a big question. So far the Governor and the bank’s research have been on very different pages.