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Rising interest rates also make it harder to buy a home.
Andrew Auerbach and Gene Blacklock are contributing columnists for The Globe and Mail. They are co-founders of Delisle Advisory Group, an independent wealth management firm for high-net-worth individuals.
In 2020, faced with soaring home prices and rising household debt, Canada's largest mortgage insurer, the Canada Mortgage and Housing Corporation (CMHC), changed its criteria to make it harder for people to qualify. CMHC did this by lowering the maximum allowable levels of household debt repayment and tightening personal credit rating criteria.
In Canada, home buyers with less than a 20% down payment are required to purchase mortgage insurance to protect lenders in the event of a default. By making it harder for such home buyers to obtain insurance, CMHC has made it harder for them to qualify for a mortgage.
CMHC's measures were seen as overly restrictive, and Canada's other two major mortgage insurers did not follow suit. As the only insurer to take steps to address rising household debt, CMHC's market share plummeted from 45% to 30% in the first quarter of 2021, reversing trajectory a year later. Home prices and debt continued to soar as buyers over-borrowed amid low borrowing costs.
Fast forward to the present, prime lending rates have nearly tripled from 2.45% to 6.95% in 2021, Canadians are beginning to feel a significant financial strain, and rising mortgage delinquency rates are hurting the performance of the big six banks.
To make matters worse, the big six banks have become more vulnerable to mortgage defaults: In 1990, the big six held 38% of the mortgage market; today, through consolidation through trust company acquisitions, they hold 73% of the mortgage market and hold $1.6 trillion of the $2.18 trillion in outstanding mortgage debt.
In their quarterly report ending April 30, the six banks increased their combined default reserves to $4.1 billion, up from $2.5 billion in the same period last year, a staggering 64% increase from 2018. Making a reserve doesn't mean the bank suspects a loan will default, it just means the loan has already defaulted and is heading for a write-off.
If the events of the past year weren't dire enough, the situation is likely to get even worse when mortgage renewals come up, when interest rates are significantly lower. Unfortunately, the majority of renewals are still to come, with the Office of Financial Institutions Oversight (OSFI) predicting that 76% of mortgages that were outstanding in February will be up for renewal by the end of 2026.
In Canada, the maximum length of a fixed rate is five years, in contrast to the U.S. While Americans buying a home in 2021 can get a 30-year fixed-rate mortgage and will pay the 2021 interest rate (likely around 2.65%) for another 27 years, Canadians who bought a home in 2021 will soon be forced to renew at significantly higher rates.
Take a $500,000 mortgage as an example: if a Canadian buyer took out a one-year loan in 2021 at a 2.79% interest rate (most people opted for the shorter term because interest rates were lowest), they would now renew at 6.79%. Their monthly payment would increase from $2,313 to $3,437, a 49% increase. But with home prices soaring across Canada, especially in major cities, many Canadians are taking on mortgages much larger than $500,000, creating additional stress.
At the beginning of the year, the general consensus was that relief through interest rate cuts was on the way. However, the prevailing view is that interest rates will remain elevated for a longer period. The Bank of Canada's 0.25 percentage point rate cut in June was a welcome relief, but interest rates are still significantly higher than they will be in 2021. This poses a major challenge for Canadians – and banks – as mortgages come up for renewal, and other household debt is also rising. Canadians' debt-to-disposable income ratio has risen from 60 percent in 1980 to 180 percent today. In fact, Canada's household debt levels are now the highest among the G7 countries.
It's hard to know what should or can be done about Canada's debt crisis, as the country has so far resisted making difficult changes, such as CMHC's futile attempt in 2020 to tighten credit requirements for mortgages.
It's easy to point to the government as the problem, but in a democracy this feels like a lazy conclusion. There are no easy answers, but ignoring the problems will create bigger problems in the future. Canada's debt will never go away, and it now makes it the G7 country most exposed to a global economic downturn.