As interest rates rise, Canadian household debt sensitivity has increased to reflect an increase in interest payments. But a further spike in rates won’t increase mortgage defaults in the foreseeable future, suggests a report issued by one of the country’s big five banks.
Instead, rate hikes are expected to stall the pace of Canadians being approved for mortgages, according to a report from CIBC published on Wednesday.
"When people think about interest rates rising the first thing that comes to mind is people defaulting on their debt, what happened in the US for example,” Benjamin Tal, CIBC Economist tells BuzzBuzzNews.
“And I said this is not the story. I think that if you look at the margins most people would be able to take care of financing their debt,” he adds.
Last week, the Bank of Canada increased its overnight rate, which influences the mortgage market, by 25 basis points to 0.75 per cent.
With the central bank expected to increase rates again by the end of this year, CIBC’s report assesses Canadian household debt sensitivity to higher interest rates.
If interest rates do continue to increase, CIBC predicts the higher rates will immediately impact about 50 per cent of total household debt, along with easing consumer spending and the growth of outstanding mortgage balances.
With the Bank of Canada raising rates and thereby driving up household debt sensitivity, Tal is concerned by potential damage caused by “policy overshooting.”
"I think that the issue is really how much money would be going towards financing the debt and how much less money would go towards consumption,” says Tal.
Currently, household debt sensitivity would be worse if it weren’t for prior changes in underwriting policies and responsible borrowing by Canadians, says the CIBC report.
In recent years, the Bank of Canada’s debt service ratio has been stable and principal payments account for a record-high 50 per cent of total household debt servicing costs.
To determine Canadian household debt sensitivity to higher rates, CIBC forecast the impact of a rise in the effective interest rate of all household debt, which is a measurement representing total interest payment as a percentage of total debt.
In 2016, the effective interest rate was roughly four per cent but if it were to increase 100 basis points that could potentially translate to 1.3 per cent of forgone consumer spending.
That measure was around 1.1 per cent before the recession in 2009, suggesting households would be 20 per cent more sensitive to higher rates than a decade ago.
When analyzing mortgage holders, homeowners who have a 45 per cent total debt service ratio are considered the most sensitive to rate hikes.
According to CIBC, this segment accounts for 10 per cent of mortgage outstanding and assuming there is no recession in the near-term, the likelihood of this group defaulting in the case of increased rates is low.
CIBC says Canada’s economy is currently a tale of growth, not credit quality. But if consumer spending and real estate activity slowed significantly then that could signal a recession.
Going forward, CIBC predicts the Bank of Canada will not move hastily when increasing rates to mitigate the effects of sensitivity.
However, with the Office of the Superintendent of Financial Institutions proposing a 200 basis point increase to the qualifying rate of the non-insured mortgage segment of the market, CIBC says that this, combined with the possibility of smaller mortgage amounts, could cut mortgage outstanding growth in half within up to two years.