How interest rates affect Canadian consumers through housing

Monetary policy affects the real economy in many ways, but perhaps the most crucial is its influence on mortgage rates.

That’s especially true in Canada, where homeowners typically have mortgages with shorter fixed-rate horizons and higher levels of debt. When rates increase, homeowners quickly feel the impact in the form of higher mortgage payments. They then reduce spending in other areas, which drags down economic growth.

This dynamic has played out over the past two years as the Bank of Canada has aggressively raised rates to tame inflation. And it has succeeded: December’s consumer price index came in at 3.4 per cent, markedly lower than a year earlier. But at the same time, the rate increases, by cooling demand, have put the economy on the precipice of a contraction.

Now, the central bank faces a decision: How far does it want to go in suppressing demand? The answer lies in the housing market. 

In the past, rate cuts have been effective in pushing down mortgage rates and encouraging people to take out mortgages. That is what precisely occurred in 2020-21. This time will be no different, as rate cuts bring relief to more homeowners when it comes time for them to renew.  

Therefore, there is an opportunity for monetary policy moderation in 2024 to help the economy get over the hump toward recovery.

The five-year fixed mortgage rates

Interest rates have a large impact on the Canadian economy because homeowners have a relatively high debt level, and crucially, because of the maximum length that Canadian homeowners can fix the interest rates of their mortgages.

This length is a pivotal difference between the American and Canadian economies. In the U.S., homeowners can fix their mortgage rate for 30 years. In Canada, the maximum length is five years, after which homeowners must renew their mortgages at the prevailing market rates.

It is easy to see, then, why monetary policy affects Canadian homeowners so much more than American homeowners. Changes in the policy rate in Canada, as a result, pass through the economy more quickly because of this difference.

For variable rate mortgages, the impact of rate changes is instantaneous. Homeowners with variable rate mortgages have been feeling the effects of the rate hikes for the past two years, each of which has increased their housing costs.

Still, about three-quarters of Canadian mortgages have fixed rates. More than one-third of Canadian mortgage holders have already renewed their mortgages during this rate hike cycle with higher payments.

In 2020-21, when nominal interest rates dropped to near zero at 0.25%, and real interest rates became negative, many people bought homes. Almost half, or 45%, of all outstanding mortgage holders, will experience sticker shock when their mortgages come up for renewal over the next two years.

Less discretionary spending

It is not unheard of for mortgage payments to go up by hundreds of dollars or even more upon renewal. For a homeowner, that means hundreds of dollars more paid toward mortgages than on discretionary spending. Multiply this by the millions of mortgages across Canada, and one can imagine the significant impact of rate hikes on the economy. 

Consumer spending per capita has been falling for six months. Even discretionary service spending has weakened.

Some homeowners turn to credit cards to finance their spending amid higher mortgage payments. Yet others choose to extend their amortization periods. Some variable rate mortgages have negative amortization, which means their fixed payments no longer cover interests and the amount they owe increases.

Even when rates begin to drop, which we expect will happen in the spring, they will do so slowly and gradually. The neutral rate—which we estimated to be between 3 per cent and 3.5 per cent—will still be higher than the policy rate in the years leading up to this rate hike cycle. As a result, required payment rates on mortgage debt will continue to climb in the coming years, presenting a drag on consumer spending.

The United States stands in contrast to Canada. About 70 per cent of U.S. mortgages are under 4 per cent, fixed for 30 years. The Federal Reserve’s rate changes have little impact on these homeowners, who continue to spend, boosting the U.S. economy, 70 per cent made up of consumer spending.

Barriers for prospective buyers and renters

High interest rates affect not only current mortgage holders but also prospective buyers and renters. Many prospective buyers, mainly millennials, are not approved to borrow as much as they need to buy, so they continue to rent.

This squeeze on buyers exacerbates the housing shortage in the rental market, which is already abysmal. The rental vacancy rate reached 1.5 per cent in December 2023, way below the 3 per cent considered healthy for urban centres. Rent growth reached 8 per cent year-over-year, above wage growth and inflation, according to the Canada Mortgage and Housing Corporation.

For more than a decade, construction has not kept up with population growth. Even with units started during the 2020-21 construction boom hitting the market, supply is falling further behind demand.

Building permits have been declining as high rates discourage developers, translating to fewer units completed two to five years down the road. That shortfall, in turn, will increase the prices of both houses and rent and restrict consumer spending even then.

The takeaway

High interest rates will have a profound impact on Canadian consumers’—homeowners and renters—housing.

We cannot expect monetary policy to address the housing shortage. Easing the Bank of Canada’s policy rate will not solve the housing puzzle. But cutting rates reduces the burden on homeowners, opening the door for prospective buyers to become homeowners and encouraging developers to add supply. All of these will bolster consumption and aid Canada’s economic growth.