North America’s triple whammy worries

Canadian consumers are facing a triple whammy, one that will impact family finances, businesses large and small, and potentially derail the economic recovery from the Covid-19 pandemic.

Home prices across Canada continue to rise to levels many people have a hard time believing. Houses and condominiums in Vancouver and Toronto are selling for a third over their asking price and real estate in other cities is going along for the ride. Housing affordability has emerged as a significant concern across the country and is rapidly emerging as the Achilles heel of lifestyles in Canada.

Three factors that have come together recently are exacerbating the problem and could make life difficult going forward.

Interest rates

The first is rising interest rates. The Bank of Canada started pushing up its base lending rate on 2 March 2022 – from 0.25% to 0.5% – and lenders quickly followed suit. It was the first hike since 2018.

The interest charged on a lot of mortgages, lines of credit and loans in Canada is ‘variable’, meaning it moves up and down along with the prime lending rate; as that prime rate goes up, so do payments. The prime rate is now 2.7% and likely to keep rising throughout the rest of the year, which will certainly squeeze wallets.

A 1% increase in rate translates into an extra C$50–C$60 per month for every C$100,000 in mortgage. And most mortgages in Canada are many multiples of that.

Home prices rose by an average of 18% in Toronto last year, putting the average at almost C$1.1m (US$867,000). Canada-wide, the average home price hit a record C$748,450 in January, up 21% on January 2021. And with the biggest cities becoming unaffordable, buyers are pushing into other cities and driving up prices there.

There are few comparisons to Canada’s bubbling market. The best similarities may be on the west coast of the US in places like Seattle or around Silicon Valley or in New Zealand, which has the only real estate market that has been as hot as Canada’s in the past few years.

Inflation

The second factor is inflation. This was already a concern before the war in Ukraine and is now front and centre. And it is not just in Canada. In the US, the consumer price index rose 7.9% year on year in February, a 40-year high, following a 7.5% increase in January.

Perhaps the most visible sign of rising prices is the cost of fuel. Petrol stations display the cost of a litre of basic unleaded in big shiny numbers. When prices topped C$2 a litre during the first week of March in British Columbia (which has the most expensive petrol in North America) and got close to that mark in Ontario, it was national news. Fuel has never been so expensive. There are now expectations that wheat-based products like flour and bread will go up significantly since Russia is a big exporter.

Salaries are not going up as fast, but the good news is that jobs are plentiful.

Sub-prime

The third potential factor is a combination of the first two. Canada did not have much of a sub-prime problem in 2008, but over the past few years the number of ‘hidden’ sub-prime mortgages has risen. For example, many borrowers now take out loans to cover the sizeable down payments required by Canadian banks, essentially borrowing the entire mortgage amount. A significant percentage of borrowers are overstretched and will be more so as rates go up.

Canada has a lot of regulations to prevent defaults, but many factors are now coming together that point to risks. The central bank highlighted the risks in its annual financial system review in May 2021, saying that the larger amounts that homebuyers are borrowing are the ‘most economically significant factor associated with future financial stress’.

High loan-to-income ratio loans (those where the principal is 4.5 times or more the annual income of the borrower) make up almost a fifth of all insured home loans in Canada, compared with one in 18 just three years ago. Meanwhile the number of mortgages going to borrowers with low credit scores increased in the third quarter of 2021 and now account for about 4.4% of all mortgage borrowers, according to Equifax, which tracks credit ratings.

There has not yet been a significant uptick in defaults, but if prices continue going up and interest rates push up the cost of borrowing, keeping up mortgage payments could become difficult. Add to that the impact of rising prices of everything from bread to fuel and the result is a difficult few months ahead.

Is the situation untenable? No. Will it require some careful navigating and decision-making? Absolutely.