Canada / Spotlight Reports
Interest Rates and Regulations Threaten Canadian Homeowners

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by Mario Ismailanji Analyst
Jan 26 2018

Last year was a banner year for the Canadian economy. Across the board, macroeconomic indicators have been positive; the national unemployment rate declined to a 41-year low in December 2017, consumer spending growth accelerated to growth levels not seen since before the global financial crisis and per capita disposable income grew faster than it has in nearly a decade. GDP growth amounted to 2.6% in 2017, a marked improvement from previous years when the economy was mired by the effects of the collapses in commodity prices. Additionally, the Bank of Canada raised its overnight rate target for the first time in two years in July and then again in September. The interest rate hikes were implemented in large part to combat expected inflation and prevent the economy from overheating.

Some signs of overheating are apparent in the Canadian housing market, however, as low interest rates heightened demand for housing and intensified consumers’ use of leverage to finance homes. In fact, a majority of the growth in aggregate household debt has been driven by increases in residential mortgage loans and home equity lines of credit. As interest rates rise, consumers who have high loan-to-value ratio mortgages may encounter difficulty when adjusting. Having already incorporated a stress test on insured mortgages, the Office of the Superintendent of Financial Institutions (OSFI) published new mortgage rules on January 1, 2018. The most significant rule requires a stress test for all uninsured mortgages, requiring the minimum qualifying rate for uninsured mortgages to be higher than the contractual mortgage rate plus 200 basis points, or the Bank of Canada’s five-year benchmark rate. Borrowers will be judged not according to their agreed-upon rate, but on more stringent standards laid out by the stress test. This will cool demand for housing moving forward, as some consumers will likely have their mortgage applications denied due to their inability to meet payments at higher rates. Here are some industries whose performance will be affected by how consumers handle new mortgage regulations, interest rate hikes and their debt levels.

A lending hand

Quite simply, industries that source a significant amount of revenue from mortgage loans will be affected greatly by these factors over the five years to 2023. Industries such as commercial banking and credit unions rely heavily on revenue generated from residential mortgages. Mortgages are projected to generate 15.2% of total revenue for the Commercial Banking industry in 2018. Similarly, an estimated 63.8% of loans issued by Desjardins Group, the largest player in the Credit Unions industry, are estimated to be residential mortgage loans. How consumers respond to stricter mortgage rules and interest rate hikes will be paramount for the performance of these industries. According to the Bank of Canada, 10.0% of mortgages over the 12 months before June 2017 would not have qualified had the new stress tests for uninsured mortgages, or those with at least 20.0% down, been implemented. The new mortgage rule will almost certainly serve to cool the housing market and prevent it from overheating further, thus inhibiting demand for a key product offering of financial industries.

canadian housing affected industries

Interest rate hikes in 2018 and beyond, however, are expected to provide a boost to operators that generate a significant proportion of their revenue from mortgages, mitigating the influence of lowered demand. For instance, the Bank of Canada raised its target for the overnight rate in January 2018 from 1.0% to 1.25%. Shortly thereafter, major financial institutions such as Bank of Montreal, Canadian Imperial Bank of Commerce, Desjardins Group, Royal Bank of Canada, Scotiabank and TD Canada Trust, all raised their prime rates to pass on the higher costs of borrowing to their consumers. While income sourced from fixed-rate mortgages will be unaffected by the rate hikes until they renew their mortgages, those who have variable-rate mortgages will likely get charged higher monthly fees. As a result, mortgage lenders are expected to reap the benefits almost immediately. Over the five years to 2017, the Commercial Banking industry grew at an annualized rate of 3.5% to $61.4 billion, while the Credit Unions industry grew at an annualized rate of 0.2% to $15.5 billion; conversely, their growth is projected to accelerate to 7.6% and 1.2% in 2018 to $66.1 billion and $15.7 billion, respectively, due to interest rate hikes.

Growing household debt

There are some concerns, however, regarding the growing levels of household debt. According to a survey released by MNP LLP in January 2018, one-third of Canadians feel they are unable to pay all their monthly bills. Additionally, nearly half of respondents indicated that they would likely have to become further indebted to cover their bills. Such sentiment is not surprising considering that, according to the latest data available from Statistics Canada, debt amounted to 173.3% of disposable income at the end of the third quarter in 2017, up from 162.9% at the same point in 2012. Over the five years to 2017, aggregate household debt, measured in chained 2007 dollars, grew at an annualized rate of 3.9% to nearly $1.9 trillion.canadian housing graph

In an environment where interest rates are likely to rise, mounting household debt that outpaces disposable income growth runs the risk of mortgage defaults and, therefore, industry contraction. While remaining high in 2018, IBISWorld forecasts aggregate household debt growth to decelerate to annualized growth of 2.4% over the five years to 2023, largely due to anticipated interest rate hikes and reduced demand for housing, the primary driver of rising household debt. The deceleration in household debt growth, coupled with steady disposable income growth, is expected to mitigate some of the risk growing household indebtedness poses to commercial banking and credit unions. Therefore, IBISWorld projects the Commercial Banking industry to grow at an annualized rate of 3.2% to $77.3 billion and the Credit Unions industry to grow at an annualized rate of 2.3% to $17.6 billion over the five years to 2023.

Residual impact

Aside from lenders that generate revenue directly from mortgage payments, there are other industries that will likely be indirectly affected by the anticipated cooling of the housing market. The Logging industry and its main downstream markets, which include industries such as sawmills and wood production, wood panelling manufacturing and millwork, are expected to grow sluggishly as demand for housing cools. Wood products are key to home construction, as support beams, flooring, doors and other home essentials are often manufactured by these downstream industries. Following the boom in the housing market, revenue generated by these three manufacturing industries grew over the five years to 2017 at an annualized rate of 7.3% to $28.7 billion. However, due to the likely housing market slowdown in 2018, revenue is expected to expand just 0.9% in 2018. Over the five years to 2023, slow growth is expected to continue, as revenue is forecast to grow at an annualized rate of 1.1% to $30.6 billion, in large part due to suppressed demand from downstream markets. Overall, the value of residential construction is forecast to grow an annualized 2.3% over the five years to 2017 to $126.6 billion, with a decline of 1.5% in 2018 alone. Despite the expected slowdown in the housing market, the value of residential construction is projected to grow at an annualized rate of 1.7% over the five years to 2023 to $137.5 billion, as the market eventually adjusts to the new mortgage rules.

canadian housing canva

Uncertain outlook

Efforts by the Bank of Canada and the Office of the Superintendent of Financial Institutions to minimize risk and ensure the economy grows at a sustainable pace will have far-reaching effects. Interest rate hikes in 2018 and beyond are expected to benefit lenders that generate a significant portion of their revenue from residential mortgage loans. Time will tell as to how successful consumers are in adjusting to higher interest payments and managing their growing debt levels.