On March 2, 2022, the daily interest rate increased by a historic 100%. This is the first interest rate hike in Canada in almost four years. In this article, I will tell you what is the impact of Bank of Canada rate hike on home prices? and how Interest Rates Affect the Housing Market.
It was clear that the Bank of Canada was going to raise interest rates from the historically low levels we have experienced over the past two years. However, we did not know exactly when and by how much. After no rate hike in January, the conversation turned to a rate hike in March, between 0.5 and 0.25 percentage points. Instead, after instability in the world and economic sanctions that we had not seen before, the conversation shifted to either not having a rate hike or having a 0.25 percent hike. In the latter case, the Bank of Canada decided to raise the overnight rate by 0.25 percent this March 2. The overnight rate is not a figure that consumers face directly. Rather, it is indirect. And what most people want to know is how this change is affecting housing prices in Canada.
I assess the impact of canadian interest rates hike on home prices based on 7 elements. I call them the fast four and the big three.
How Interest Rates Affect the Housing Market, No.1 — Inflation
The first of the fast four is inflation. According to the latest inflation figures, the Canadian Consumer Price Index (CPI) is 6. 7%, above the forecast of 5. 8%. And when inflation goes up, so do housing prices. This is mainly due to the input costs involved. When the consumer price index is high, people demand higher wages, and so things like bricks or anything used in a house become more expensive. This increases their replacement value, which increases the value of a resale interest.
How Interest Rates Affect the Housing Market, No.2 — Exchange rate
The second quick look at our exchange rate: when we talked about it in late January, the currency hadn’t changed much since the last interest rate decision. From then to now, the Canadian interest rate is down about 2%, but that’s not a big change.
How Interest Rates Affect the Housing Market, No.3 — Supply constraints
The third point refers to supply constraints. When we talk about supply constraints, we are referring to how many homes are put on the market. In the last two years we have had a historically low level of supply. Now some homes are coming back on the market, although they are very few by historical standards there are more homes coming on the market
How Interest Rates Affect the Housing Market, No.4 — the “price of certainty”
The fourth point we quickly talked about is the “price of certainty”. In other words, do you know how much your home might sell for or what its approximate value is? And how much will the home you want to buy cost you? If you don’t know what the price will be, we call it a “risk premium”. In other words, ask a little more when you sell, so you can afford to buy the house even if you want to buy it.
In the last couple of years, we’ve seen a lot of people sell a house or a condo, wait a few months and then find out they can’t even buy the house they sold. It’s a pretty terrible situation. To avoid that, when prices are uncertain, people ask for higher prices, and prices keep going up. Right now, we have some price security because the market has calmed down a little bit. But now that we have introduced a price change in the market, prices will be very uncertain, maybe they will go down, but they can also go up. And if we have uncertainty about prices, there is a higher “risk premium”, which means that real estate prices will go up.
Above are the four key factors I look at to see trends in property prices as they increase. But next, I will discuss the three big factors that I always talk about that are fundamental to the market at any given time. These three are the ones that make the biggest difference in house price movements because they have the ability to control the market at the extremes. If any of these three things change in an extreme way, we will have significant changes in house prices or in house prices across Canada. That’s why I always pay attention to those three things.
The Impact of Bank of Canada rate hike on home prices, No.1 — The liquidity of the lender
The first of the three key criteria is the liquidity of the lender, which affects the house prices which will continue to rise. If lenders stop lending money and people can’t get the mortgages they need, housing prices go down, because the only potential buyers are people who have made a large down payment or have the ability to buy with cash. We’ve seen this several times in history when the mortgage taps are turned off. This is something they were worried about in March and April 2020, which triggered quantitative easing. But there is still a lot of liquidity in the market right now. And one of the important factors coming out of this interest rate announcement is that they’re not going to start what they call quantitative tightening, which is taking mortgage money out of the market. So lenders are remaining liquid which suggests that there’s a lot of money in the market right now. And that means that house prices will continue to rise.
The Impact of Bank of Canada rate hike on home prices, No.2 — Government intervention in the housing market
The second of these three main factors, which causes the biggest change in the market, is government intervention in the housing market. This means that the government enters the game. It creates a rule and that rule creates a whole change in demand or supply in the market. The most important one we talked about last year was the run-up to the 2021 election. The Liberal government promised to ban foreign buyers. They talked about banning foreign buyers for 2 years and yesterday they had to vote on it internally. It was voted down 6 to 5 in a very close vote, which means that foreign buyers are still allowed to buy real estate in Canada. At this time, there is no other major government intervention planned for Canadian real estate, specifically for the housing market, which means that, without government intervention, we will see the market continue to grow.
The Impact of Bank of Canada rate hike on home prices, No.3 — The evolution of interest rates
The third of these three big issues are the focus of this article. It is the evolution of interest rates. The overnight rate has doubled from 0.25 to 0.5, which means that the prime rate for banks, which is the figure that most consumers work with, will go from 2.45% to 2.7%. But what does this mean for you as a homeowner? If you have a fixed-rate mortgage, it means absolutely nothing until the renewal period. If you renew your mortgage today, it will be 0.25 percentage points higher.
If you have a variable rate mortgage, which is affected by interest rate changes, this directly affects you as mortgage holder by increasing your monthly interest payments.
In Canada, there are two main structures for adjustable-rate mortgages. Half of them increase the monthly payment when the interest rate increases. The other half do not increase payments. All you mean is that you work from the beginning to the end of your term. If you’re concerned about the type of variable interest rate, it’s best to call your lender and find out before your next payment, because it could be that the cost of the interest rate will increase, or it could stay the same and you’ll only have to deal with it at the end of the term. Either way, if your variable is fixed, it is likely to have been stress tested because 90%+ of mortgages in Canada have been stress tested somewhere between 4. 8% interest and 5.25% interest. So the interest rate on your mortgage drops from about 1.5% to 0.25%. This means you are still 3% below what you could pay if interest rates continue to rise. The 0.25 percent rate increase has no impact on fixed rate holders and minimal impact on variable rate holders.
What is more important is the direction of these rate increases over time. 0.25% here and there will not really have a direct impact on the market, but several quarter points toward 2% or 3% will have an initial impact on the market. 90% of homeowners with mortgages have shown that they could carry a mortgage that is at least 3% higher than what they are currently paying. As a result, we won’t see the main impact of the rate hikes until we add another 2.75% or more.
Canada’s central bank has signaled that it will continue to raise interest rates until the market stabilizes and is satisfied with interest rates. But for now, We’re not sure what will happen. Don’t expect a rate hike at every budget meeting this year, and they will be very cautious. Remember, after the 2008 rates, they raised interest rates too fast, which caused another recession that forced them to lower interest rates again. They don’t want to go through that scenario today. We’re still dealing with the consequences of a pandemic, and all kinds of instability in Europe. So let’s be very careful with these rate hikes, because raising interest rates the wrong way could plunge us back into a recession.
How Interest Rates Affect the Housing Market — The result
So back to our seven points to watch out for. Of our four quick indicators, two show that the market is going up in real estate prices. One is stable, which means prices are still rising. And one, prices may be falling, but not very fast.
For the big three categories, liquidity has remained the same, there has been no government intervention. We’ve certainly started to raise interest rates, but only by a very small amount, and the Canadian central bank is under pressure to make sure they don’t raise rates too quickly.
Right now, the Canadian housing market doesn’t seem to be showing any signs of slowing down, but the Bank of Canada is hoping that at least the first interest rate increase and the promise of future increases will give people a break and make sure they don’t overspend.
The goal of this first Canadian interest rate hike is not to materially slow the market, but rather to signal a consistent approach to rate hikes over the next year or two. The Bank of Canada is making sure it is sending a signal of what it says it will do going forward. However, as things stand, a 0.25% rate hike does little to change what is happening in the market. The main reason this rate hike will not have a dramatic impact on the market is because of so-called negative real interest rates.
Our last CPI index report was 6.7% and you can currently get a variable rate mortgage for less than 2%. That means you have a negative real interest rate of around 5%. You borrow money at 2%, but your equity, if it keeps pace with inflation, will increase by 6.7%. If you borrow $1 million and it keeps up with inflation, it will increase by $67,000 and cost you less than $20,000 in interest to keep it. You would have to earn 5% more income just to keep up with inflation. This is how the negative real interest rate works.
Negative real interest rates are good for a depressed economy. That is, when you borrow money at an interest rate below the value of inflation, inflationary pressure actually pays you money because what you buy today will continue to increase in value in an inflated market. And at that point it makes sense to borrow as much money as you can and spend on real estate in an economy to benefit from inflation.
Investors in this economy are encouraging business, by spending and investing. And it has played a crucial role in helping Canada avoid a real estate recession in 2020 and 2021. However, right now people are not borrowing money to invest in business assets, they are borrowing as much money as they can to invest in real estate.
Now the average homeowner is competing for that property with family investors and large conglomerates, which is driving up prices. And with real negative interest rates -5% according to the CPI, if you apply that to real estate and the market was yielding 28% last year in Canada, real negative interest rates are well over 20%. It doesn’t make sense to have invested elsewhere.
Unfortunately, the government can’t decouple real estate from negative interest rates and can’t raise rates without affecting business investment. Not to mention the impact higher interest rates will have on the government’s cost of carrying its own debt. What does this mean for the Canadian real estate sector? In the short term? Expect a 2-3 week recession as the market adjusts to what will happen with higher interest rates. Then we will see growth. The housing market is expected to recover before the rate announcement in April. And after that, we’ll have a better idea of what the Bank of Canada plans for the rest of 2022. But as it stands, without significant intervention or interest rate adjustment, we will see prices continue to rise. The only other way we see the Canadian housing market falling right now is the sharp drop in consumer confidence. This is not likely to happen as house prices continue to increase.
On March 2, 2022, the Bank of Canada did the least it could. It felt it had to maintain stability in the market. A small Canadian interest rates hike would not dramatically change prices. Instead, it made the decision that the Canadian housing market could continue to move upward.
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