Navigating Canadian Mortgage Rates: An In-Depth Look at Economic Headwinds and Mortgage Choices

The landscape for Canadian mortgage rates appears to be entering a period of unexpected calm, offering both a silver lining and a cause for concern for homeowners and prospective buyers alike. While the good news suggests that mortgage rates are unlikely to climb higher this year, the underlying reason points to a slowing Canadian economy. This intricate balance between stable rates and economic deceleration presents a complex picture for the Canadian housing market and its participants.

David Larock, President of Integrated Mortgage Brokers in Toronto, provides a clear perspective on the current economic trajectory. He postulates that any upward movement in mortgage rates would typically signal an economy on the rise. However, Larock expresses skepticism about an imminent economic improvement, leading him to predict that both five-year fixed and five-year variable mortgage rates could very well be lower within the next 12 months. This forecast is underpinned by a broader consensus among economic forecasters who anticipate the long-standing U.S. economic expansion nearing its conclusion. Should both the U.S. and Canada face a recession this year, a downturn in mortgage rates is almost a certainty, given the historical trend of rates falling during economic contractions.

The Bank of Canada’s Stance and Economic Slowdown

The Bank of Canada (BoC) has implemented five interest rate hikes since July 2017, a series of adjustments aimed at normalizing monetary policy. Yet, recent indicators suggest a pause in this tightening cycle, with further rate increases appearing unlikely for the foreseeable future. The central bank itself acknowledges that the full impact of these rate adjustments can take anywhere from 18 to 24 months to permeate through the economy. This means that the cumulative effect of these past rate hikes is only now beginning to manifest, and the Canadian economy is expected to continue feeling their influence well into late 2020.

This delayed impact contributes significantly to the anticipated economic slowdown, dampening prospects for rate increases. The BoC’s cautious approach reflects a recognition of these lagging effects and a desire to avoid exacerbating any nascent economic weakness. For Canadian homeowners and businesses, this implies a period of adjustment where the cost of borrowing may stabilize, but the broader economic environment could present new challenges.

The Dominant Influence of the U.S. Federal Reserve

The monetary policy decisions of the U.S. Federal Reserve (the Fed) exert a profound influence on the Bank of Canada. If the U.S. economy experiences a slowdown or enters a recession, the Fed would likely reverse its course on interest rates, moving towards reductions. Indeed, by late January, the Fed had already signaled that it did not foresee any immediate additional rate increases, a significant shift from its previous hawkish stance. Larock emphasizes the critical implication of this for Canada: “If the Fed lowers rates, the Bank of Canada simply has to follow.”

The rationale behind this interdependence is straightforward yet crucial for Canada’s economic stability. Should the Fed cut rates while the Bank of Canada maintains its position or even raises rates, the Canadian dollar (often referred to as the “loonie”) would experience a significant appreciation against the U.S. dollar (the “greenback”). This surge in the loonie’s value would severely impact Canadian exporters, making their goods and services more expensive in international markets and thus harming their competitiveness and profitability. To prevent such adverse economic consequences, the Bank of Canada typically aligns its interest rate policy with that of its powerful southern neighbor, ensuring a more balanced exchange rate and supporting Canada’s export-driven sectors.

Fixed vs. Variable Mortgages: A Strategic Decision

When it comes to choosing between fixed and variable mortgage rates, there is no universal answer; the optimal decision hinges entirely on an individual homeowner’s specific financial situation and risk tolerance. Larock points out that, currently, there isn’t a substantial discount to be gained by opting for short-term fixed mortgages (one or two years) over a five-year fixed term. He advises that a shorter fixed term only becomes financially sensible if it comes with a significant interest rate reduction. Without such a compelling incentive, the perceived flexibility of a shorter term often doesn’t outweigh the benefits of longer-term stability.

Borrowers generally pay a premium for fixed-rate mortgages, essentially purchasing “rate insurance” against future interest rate fluctuations. This premium provides the invaluable benefit of payment stability, allowing homeowners to budget with certainty for the duration of their fixed term. This stability is particularly appealing to individuals who prioritize predictable expenses and wish to avoid the potential stress of fluctuating payments.

Conversely, variable rate mortgages are often a more suitable option for more established buyers. These individuals are typically comfortable with the inherent fluctuations in payments and possess sufficient income buffers to comfortably absorb any increases. Larock, while acknowledging the decreasing magnitude of potential savings compared to the past, still bets on variable rates proving to be more economical over the next five years. However, he cautions that these savings may not be as dramatic or as “compelling” as they have been in previous economic cycles.

Frank Napolitano, a mortgage agent and founder of Mortgage Brokers Ottawa, echoes Larock’s sentiment regarding the Bank of Canada’s reluctance to raise rates further this year, stating it would cause “way more damage to the economy than good.” Napolitano highlights the current attractiveness of five-year variable rate mortgages, with some lenders offering rates as low as prime minus 1.1 points (equivalent to 2.85 percent in late January). Despite the appealing rates, he stresses the importance of individual “risk tolerance.” Pushing a highly conservative borrower into a variable mortgage could lead to prolonged anxiety, making it a potentially ill-advised choice. Interestingly, Napolitano observes that a significant portion of his clientele, approximately 35 to 40 percent, are currently opting for five-year variable terms, indicating a notable level of comfort with this mortgage product among a segment of the market.

The Mortgage Stress Test: A Major Hurdle for Homebuyers

While mortgage rates have seen increases since 2017, the most formidable obstacle for aspiring home buyers in Canada remains the mortgage stress test. Introduced as the B-20 Guideline, this regulatory measure makes it considerably more challenging for individuals to qualify for mortgages, even if they can comfortably afford the actual payments at prevailing market rates. The stress test mandates that uninsured borrowers must qualify at the greater of the Bank of Canada’s benchmark qualifying rate or their contractual mortgage rate plus two percent. This higher qualification bar significantly reduces the borrowing power of many Canadians.

The repercussions of the stress test are evident in the evolving landscape of home financing. Napolitano notes a growing trend where the “mom and dad bank” is increasingly called upon to assist with down payments. Moreover, in an alarmingly high number of cases, parents are co-signing mortgages for their adult children simply to enable them to afford a home. Many of these individuals, he points out, would have easily qualified for a mortgage before the introduction of the stress test. This reliance on familial support underscores the profound impact the stress test has had on affordability and accessibility to homeownership, particularly for younger generations.

Will Dunning, chief economist at Mortgage Professionals Canada, provides further insights into the stress test’s broader economic effects. His report indicates that the reduction in the Canadian housing market last year, while partly due to interest rates, was exacerbated by the mortgage stress tests. Dunning highlights that the resale housing market remains subdued, and he does not anticipate a swift recovery to normal activity levels. This prolonged market sluggishness, coupled with stricter qualification rules, effectively denies a growing number of young, middle-class Canadians the opportunity to build their financial futures through homeownership, creating long-term socio-economic implications.

Exploring Alternative Mortgage Products

In response to the challenges posed by the mortgage stress test, several lenders outside of the traditional “Big Five” banks, such as First National, have begun offering alternative mortgage products. These innovative solutions are designed for individuals who do not meet the stringent qualification criteria of conventional mortgages under the stress test. However, Napolitano clarifies that these secondary mortgages are generally not tailored for first-time home buyers.

Instead, these alternative products are better suited for specific demographic segments. This includes individuals who have diligently saved enough for a substantial 20 percent down payment but are self-employed and thus struggle to qualify with traditional banks due to their irregular income structures. Another significant group benefiting from these alternatives are couples undergoing matrimonial breakups, who may require specialized financing options during a transitional period. Napolitano observes, “That’s what we’re seeing a lot of,” indicating a growing demand for these flexible, non-traditional mortgage solutions among a diverse range of borrowers facing unique financial circumstances.

Future Outlook and Mortgage Renewals

Despite the prevailing challenges, particularly the stress test’s impact on new buyers, the outlook for the majority of existing mortgage holders nearing renewal appears more manageable. Dunning’s analysis suggests that most borrowers who expect to renew their mortgages in the near term will experience either minimal change or manageable increases in their mortgage costs. This provides a degree of reassurance for the vast majority of Canadian homeowners who are already on the property ladder.

However, Dunning’s data also identifies a vulnerable minority: a very small percentage of mortgage borrowers, estimated at perhaps one percent or roughly 50,000 out of six million mortgage holders, are projected to face substantial and challenging cost increases this year. These individuals may require careful financial planning and potentially professional advice to navigate their renewed mortgage terms. Overall, the Canadian mortgage market is characterized by a dichotomy: a tough entry point for new buyers due to regulatory hurdles, but a relatively stable environment for most existing homeowners, albeit with a watchful eye on economic shifts and the lingering effects of past policy decisions.