It’s been a top economic story in Canada in the past year or so. Headlines of “Inflation running rampant”, “Bank of Canada Rate Hike Announcement”, Interest Rates on the Rise” have been flooding our newsfeeds and the impact of both higher interest rates and inflation have impacted the bottom line of many households. This is nothing new. However, over the past few weeks, I’ve been having this conversation with more and more clients, with a common question being, why?
Why is the government making my life more expensive? How is anyone supposed to live in an economy like this? Shouldn’t the central bank be trying to make life easier for citizens?
These are all fair questions to ask.
However, like everything in economics, the answers are not so simple. It’s an inexact science, with multiple variables, moving targets, and human participation in the system. Full disclosure, my studies in economics ended after year three of my undergraduate as I pursued my career as a Mortgage Agent. These are my thoughts on other ideas from far more intelligent people than me. But, I hope this blog, and any future content, can help make sense of what is happening in our economy, and why lenders act the way they do.
Why the Bank of Canada Has Been Raising Interest Rates
Central banks increase interest rates as a monetary policy tool to manage inflation and stabilize the economy. By adjusting interest rates, central banks aim to influence borrowing costs, investment decisions, and overall economic activity. Here are some key reasons why central banks might choose to increase interest rates related to the property market:
To control inflation:
One primary objective of central banks is to maintain price stability. As inflation rises above the target level, central banks may increase interest rates to curb excessive borrowing and spending. Higher interest rates increase the cost of borrowing, thus discouraging consumption and investment, leading to reduced demand and, in turn, helping to cool down inflationary pressures.
To manage economic growth:
Central banks monitor economic indicators to ensure sustainable growth without overheating the economy. Rapid economic expansion can lead to resource constraints, labour shortages, and increased inflationary pressures. By raising interest rates, central banks aim to moderate borrowing and spending, slowing down the pace of economic growth to prevent imbalances and maintain stability.
To encourage saving and reduce debt:
Higher interest rates incentivize saving and discourage excessive borrowing. As rates rise, saving money in interest-yielding accounts and investments becomes more appealing. As a result, this help to increase national savings that fuel productive investments for sustained economic growth. Additionally, higher interest rates make borrowing more expensive, which may discourage consumers from taking on excessive debt, contributing to financial stability.
To address asset bubbles:
Central banks are concerned about speculative asset bubbles forming, such as in housing or financial markets. When prices of certain assets rise rapidly, driven by excessive speculation and borrowing, it can lead to unsustainable valuations and potential financial instabilities. Central banks may raise interest rates to cool down such asset bubbles by making borrowing more expensive, thus dampening speculative demand and reducing the risk of a sudden burst.
Cooling the housing market could be a primary objective of rising interest rates. Property prices increased dramatically over 2020-2022 in no small part due to the cheap credit (low-interest rates) available.
It is important to note that the decision to increase interest rates is complex and depends on various factors, including the central bank’s mandate, economic conditions, inflation expectations, and the overall assessment of the risks and benefits to the economy. These factors leave out a host of other macroeconomic shifts happening across the globe, including the fallout from the Russo-Ukraine War, building trade tensions between economic powers, and the discussions around a new, BRICS-based international reserve currency to rival the USD.
How This Impacts Your Mortgage
From March 2022-July 2023, the Bank of Canada Policy Interest Rate increased from 0.50% to 5%, a 4.5% increase! Your mortgage provider will likely have a prime rate pegged to the Bank of Canada Policy Interest Rate, (usually around BOC Interest Rate +1.5% or 2%). Therefore, as the BOC policy interest rate increases and decreases, so does your lender’s prime rate. This impacts the three primary mortgage structures in 3 different ways:
- Adjustable Rate Mortgage: These are mortgages with a fixed amortization schedule for principal payments, with adjustable interest rate payments. Meaning, your payments will increase as the interest rate on your loan goes up. If the BOC benchmark rate increases by 0.25%, your mortgage interest rate will do the same.
- Capped Variable Rate Mortgage: These are mortgages where your payment remains fixed at the original amount. As interest rates rise, your payment stays the same. However, the proportion of interest in your payment increases until it reaches 100% of your original payment. After this “trigger point occurs, the additional interest charged will be capped back into your mortgage increase, causing your amortization period to increase. This results in you owing more than your original loan amount at maturity!
- Fixed Rate Mortgage: These mortgages carry a fixed rate throughout their term. Interest rate fluctuations do not impact your monthly payment directly. However, if you are in a low fixed-rate mortgage that matures when rates are high, you need to be prepared to either increase your payment substantially to maintain your loan repayment schedule, or, stretch out your amortization for cash flow relief.
If you’re like most Canadians, your mortgage is your largest monthly expense. Even the smallest change in interest rate can impact your bottom line. If you have a renewal coming up and are feeling the pinch of increased payments, or are curious about how these rates will affect your long-term balance sheet and wealth; chat with a licensed professional to help make sense of the market.
Book a meeting with a licensed professional today to review your mortgage and make your you know exactly where you stand.
