Canada’s Low Interest Rates: Good News and Bad News

Mortgage Interest Rate PuzzleCanada’s mortgage interest rates have been near historically low levels for years, and because of current global economic conditions, rates are not expected to rise significantly until 2013. If you’re shopping for a mortgage, that’s great news. But an extended period of low interest rates is taking its toll on the economy.

Bank of Canada Governor Mark Carney recently told a Parliamentary committee in Ottawa: “One of the great risks in the current environment is that Canadians take low interest rates – very low, extremely low, historically low interest rates – for granted, and they construct their financial affairs, with very long-term liabilities such as a mortgage, on the expectation that interest rates will basically stay at these levels over the life of that mortgage.”

Carney added: “In taking on a longer-term debt, people should look at their ability to service it at a more normal rate of interest…Canadians can make their own judgments about what normal is, but it’s considerably higher than rates are today.”

The International Monetary Fund (IMF) also has some concerns, saying that “household debt is at a historical high relative to disposable income, and various indicators suggest that house prices in some regions are above levels consistent with economic fundamentals.” It notes that the government has responded by tightening mortgage insurance standards, making it tougher to qualify for an insured mortgage and eliminating long amortization periods. The IMF says if house prices and household debt “continue to rise much more rapidly than disposable income,” further measures may be needed. These could include larger down payment requirements for new mortgages and “a further tightening of the existing cap on debt service-to-income ratios. Continued tight supervision of the financial institutions would also ensure conservative underwriting standards and an adherence to the existing regulations.”

Douglas Porter and Benjamin Reitzes of BMO Economic Research, in a report called The Many Dangers of Low-for-Long Interest Rates, say that a “long period of deeply negative real interest rates is quite simply abnormal.”

They point out that low interest rates discourage saving because the savings rates are so low. It may encourage inappropriate risk taking by seniors and Boomers who are worried about having enough retirement funds. It also threatens the health of pension plans.

In addition to encouraging households to take on debt, it also risks inflating a housing bubble, say Porter and Reitzes. “Average home prices have more than doubled in the past 10 years, and are up more than 20 per cent in the last three years alone, both far above personal income growth. While affordability remains reasonable, the long stretch of solid gains could set the stage for more speculative activity.”

Writing about the Greater Toronto Area, economist Will Dunning says the average resale home price grew by 78 per cent from 2000 to 2010. In a report (for the builders’ association RESCON, Dunning says, “While house prices have surged, reductions in mortgage interest rates means that the affordability of home ownership remains comfortably within historic bounds.”

Dunning argues that consumers are not receiving the full benefits of that affordability space because it “has enabled governments to raise the costs that they impose on new homes, including both direct costs (such as GST/HST and development charges) and indirect costs” such as escalating development standards and other regulations. He says the “rapid rise in house prices that has been precipitated by lack of supply affects all home buyers, including buyers of resale homes, not just new home buyers.”

National Bank Financial’s Shuba Khan says Canada’s real estate market will likely slow down in 2012 and 2013 but it won’t crash. This is in line with most forecaster predictions, although doomsayers have been predicting for years that Canada’s housing market is a bubble that’s ready to burst.

Dunning disagrees with this assessment, noting that “a severe downturn in house values would require a trigger. The U.S. experience had multiple triggers, including interest rate resets (mortgages that were initiated at below-market interest rates and were unaffordable once rates were reset at market levels). At the same time there was a sharp rise in the cost of living … .”

Dunning says, “Cautious behaviour by Canadians (consumers and lenders) means that we have the greater ability to tolerate future rises in mortgage interest costs, if and when they occur.”

Unlike many analysts who believe that house prices in Canada will level off or begin to drop, Dunning thinks they will keep going up. He says his analysis shows that “interest rates affect house prices with quite long lags … . It appears that prices do not yet fully reflect the current low level of interest rates and there is potential for further rapid price rises. The deceleration scenario might not start to unfold until 2014 or even later.”

He says, “Even if interest rates do not rise to the extent assumed… house prices would eventually find an equilibrium level. If, for example, rates stayed at current levels, they might continue to rise rapidly for another five or six years, at which point house prices might be 30 to 35 per cent higher than they are today.”

Written by Jim Adair