Record low interest rates during the pandemic have fuelled Canada’s housing market as  homeowners ride a wave of soaring housing prices. This tide is set to go back out to sea as the Bank of Canada looks to increase interest rates, possibly stranding many homeowners with large mortgages and higher mortgage rates. While we know that interest rates can’t stay this low forever, a question that homeowners might have is: why? Why can’t interest rates remain at their current levels?

One of the main goals of the Bank of Canada is to keep inflation low and stable. This is largely done by changing the Bank of Canada’s key policy interest rate. Lowering the overnight policy rate encourages spending and borrowing, helping to increase economic growth. Increasing the policy rate has the opposite effect.

Increased economic growth leads to higher inflation, while slowing down growth can help reduce inflation. The Bank of Canada has a target inflation range of 1% to 3%, with a midpoint inflation target of 2%. If inflation dips below 1%, the Bank of Canada can take action by decreasing the policy rate. This was done in March 2020 when the Consumer Price Index (CPI), a measure of inflation, had a year-over-year change of less than 1%. The CPI’s 12-month percentage change remained below 1% until October 2020, before skyrocketing to 3.6% in May 2021.

Just as the Bank of Canada cut interest rates when inflation fell below 1%, it’s generally expected that interest rates will rise with inflation now well above 3%. While the Bank of Canada has already projected that they won’t increase their overnight target rate until 2023, the Bank’s policy rate isn’t the only thing that impacts mortgage rates in Canada.

Increasing Bond Yields

Government of Canada bond yields have almost tripled since early 2020, with the 5-Year Government of Canada bond yield increasing from 0.30% in August 2020 to 1.00% in June 2021. The 5-year bond yield is especially important because fixed mortgage rates generally follow it. While mortgage rates haven’t tripled in the past few months, mortgage rates have definitely increased.

Government bond yields are expected to almost double again in the next year. TD Economics expects the 5-year government bond yield to increase to 1.90% by the end of 2022, while Desjardins forecasts it to increase to 2.35% by 2025. This will only serve to further push up fixed mortgage rates.

Prime Rates

The Bank of Canada’s overnight rate sets the way for prime rates, which impacts variable mortgage rates. Forecasts from Canada’s major banks indicate an expectation for the overnight rate to increase even before 2023.

RBC Economics predicts that the overnight rate will stay at its current rate of 0.25% until halfway through 2022, and then a quick rise to 0.75% by the end of 2022. TD Economics echoes the same sentiment, although at a slower pace, ending 2022 with an overnight rate of 0.50%.

How will the overnight rate expected to increase by 300% in one year affect prime rates? For starters, the prime rate will surely rise, bringing variable mortgage rates up with it. The prime rate has stayed steady at 2.45%, but Desjardins forecasts the prime rate to end 2022 as high as 3.45%. The 1% difference between 3.45% and 2.45% will cause variable mortgage rates to increase by over 40%. This will drastically affect the borrowers of variable-rate mortgages.

Looking towards 2024, the prime rate is expected to be as high as 5.30%. That would be a 116% increase.

Fixed Mortgage Rate Predictions

Based on a current posted 5-year fixed mortgage rate of 4.74%, Desjardins expects fixed mortgage rates to increase up to 0.5% by the end of this year, another 0.75% by the end of 2022, 0.4% in 2023, and 0.35% in 2024.

This would lead to an upper-range estimate of the posted 5-year fixed mortgage rate being 6.95% in 2024. Compared to the current rate of 4.74%, this would be a 46% increase in mortgage rates over the next three years.

Desjardins Mortgage Rate Forecast

Source: Desjardins June 2021 Retail Rate Forecasts

How Will This Affect My Mortgage?

An 46% increase in fixed mortgage rates doesn’t sound appetizing, and a 116% increase in the prime rate doesn’t seem great either.

If we were to look at a $500,000 mortgage with a 5-year term, amortization of 25 years, and monthly payments:

• A fixed rate of 4.74% would have a monthly payment of $2,834
• A fixed rate of 6.95% would have a monthly payment of $3,487

For fixed-rate mortgages, your monthly mortgage payment would increase by $653.

• A variable rate of 2.45% would have a monthly payment of $2,227
• A variable rate of 5.30% would have a monthly payment of $2,994

For variable-rate mortgages at exactly the prime rate, your monthly mortgage payment would increase by $767.

This increase would increase your required monthly payments by hundreds of dollars, while the cost of your mortgage interest would increase by thousands of dollars.

Homeowners and borrowers will want to pay particularly close attention to mortgage rates. While the mortgage stress test is designed to avoid having borrowers being unable to afford their mortgage if rates increase, borrowers that use alternative lenders that bypass this test can be particularly vulnerable. With housing prices soaring but mortgage rates lagging behind, new homeowners are in for a surprise should interest rates increase as expected over the next few years.

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Logan Leo

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