Canadians Are More Indebted; Low Rates Did Not Improve Real Estate Affordability: BoC

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.

12 Comments

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  • J_Morrow 12 months ago

    How to Blow a Bubble for DUMMIES!

  • Investor 12 months ago

    We’re all collectively making the banks happy. Banks are invincible.

    • Doomcouver 12 months ago

      Why do you think Canada’s banks have been aggressively diversifying outside of Canada? They know what’s coming.

  • Baron 12 months ago

    Banks have no risk in Canada.

  • common man 12 months ago

    If the government creates an illusion that the house prices will never come down and incentivizes to buy/keep houses , and govt does not keep a check of money laundering , the house prices will reach new highs every year probably another 25 % by next year.
    No one wants to invest in businesses or companies as everyone feels housing is the best and profitable investment.

    • J_Morrow 12 months ago

      Do you think this will be the first bubble in history that doesn’t pop? This only ends in collapse or confiscation. I’m not pretending I know which or when.

      • Average Man 12 months ago

        Yes. I don’t think housing will collapse, I think the entire economy will collapse under the weight of the housing market. We’ve missed all the logical off ramps. This will inflate for another few years and then it will break everything.

  • Scott 12 months ago

    When I become King of Canada, I know who I’ll tap for my Governor. Thanks! Insightful as always…

  • riksaga 12 months ago

    The plebes are trying live like the elites – financialization of capital & debt vs productive industrialization – can an economy sustain this – hmmm/

  • JamesXK 12 months ago

    No worries! The federal (Liberal) government will have mortgage relief programs ready for all, continue to subsidy/import new housing customers at a rate of 400k per annum, shrug off declining cad values as good for Canadian producers /exporters (and jobs), and re-direct market-exiting capital to increasing the housing supply through corporate-friendly tax-reduction schemes. The cake is already baked – everybody gets a slice.

  • D 12 months ago

    Realistically I only see two solutions:

    1)the government/central bank saves the commercial bank and the dollar, immediate consequence is that mortgagees go bankrupt and lose their home, economy collapses but there will be a recovery
    2)government does not save banks or dollar, entire economy collapses, Canada will become more like Argentina and there will be mass emigration of skilled people leading to brain drain

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