a less distressing narrative about interest rates

Over the past year, much ink has been spilled over the not-insignificant impact that rising interest rates have had, and will have, on housing markets around the world, including here in Canada. As it relates to homeowners with mortgages, the narrative is particularly distressing, with the prime rate (which governs variable mortgage rates) having risen from an historical low of 2.45% three years ago to 7.20% today, while those of the five-year fixed variety—typically the most popular choice among owners—have skyrocketed from 1.39% to 5.19% over the same period. 

This is a distressing narrative to be sure—but there are a couple of important, and often overlooked, qualifiers that are necessary to append to any discussion of rising borrowing costs to more fulsomely comprehend the situation we have on our hands.

CAVEAT NO. 1: THE EFFECTIVE INCREASE IN RATES IS OVERSTATED

While it’s true that mortgage payments have risen for most homeowners that have renewed over the past couple of years—and will certainty rise for those renewing in at least the next two—it must be pointed out that 5-year fixed-rate mortgage holders are not typically subject to the full extent of interest rate changes that transpire over periods spanning fewer than 60 months. Indeed, this is, for many, precisely why they chose to fix their payments for a full five years.

For example, while anyone with a 5-year fixed rate mortgage that’s renewing today is facing the prospect of financing at 5.19% (the going rate for a discounted, fixed, 5-year term), they wouldn’t, under normal circumstances, be renewing from the low of 1.39% last seen in February 2021. Why not? Because that rate was last available less than three years ago. Instead, today’s renewers are doing so from an interest rate they agreed to five years ago: 3.19%. While today’s going rate is 200 basis points higher than that originating rate—meaning that a mortgage payment is indeed likely to cost more now—it’s much less of an increase than is implied by looking at the full breadth of rate escalation we’ve experienced over the past three years.

CAVEAT NO. 2: AS IT TURNS OUT, THE STRESS TEST HAS SERVED A PURPOSE

For those of us in expensive housing markets that are doing all we can to be able to afford a home that meets at least some of our needs, the mortgage “stress test”—a colloquial term for federal rules that effectively restrict the dollar amount financial institutions can lend to borrowers—has been something of a pariah.

The amount of money homeowners can borrow is determined by a variety of factors, including (primarily) the borrower’s income, the size of their downpayment, the length of their mortgage amortization (e.g. in how many years the mortgage will be fully paid), and the interest rate on offer. The higher the rate, the less one can borrow (all else being equal); the lower the rate, the more one can borrow. The stress test works by “qualifying” borrowers at an interest rate that’s higher than the one actually on offer, typically by 2 percentage points. As an example, if today’s rate is 5.19%, the amount of money a borrower can access will be determined, in part, by using an interest rate of 5.19% + 2.00% = 7.19%. The purpose of the stress test is to limit risk to the financial system (and to households) of rising interest rates; on the whole, it’s quite reasonable in its construction and application.

When rates were low and falling, many questioned the need for such a high (interest rate) hurdle to be cleared by borrowers, especially in Canada’s most expensive markets. Today, the prior application of the stress test to homeowners that are currently renewing their mortgages has done its part to ensure that borrowers can continue to afford to live in their homes, despite the much higher cost of money. For instance, while today’s 5.19% 5-year fixed mortgage rate is two whole percentage points higher than the rate most are renewing from, it is precisely the rate that many were qualified at five years ago. In other words, the stress test was built for market conditions that we’re experiencing now. 

This is not to say that renewing at higher rates doesn’t come with a downside: for the vast majority of renewers it means higher payments, necessitating a reallocation of spending and saving for some, and for others requiring more strategic financial management to ensure continued affordability—even if their incomes have been rising over the years.

With 45% of all outstanding Canadian mortgages set to renew in the next two years (and 60% in the next three), how—and how much—rates change will be a point of continued interest for all of us, with implications for household saving and spending, the labour market, and, of course, our housing markets.