Like Nick, I've been thinking and worrying about the Canadian housing market, but not blogging about it. I've decided that it's worth putting some points out for discussion on the topic, if only because it's something we should be talking more about. I've broken it down to three separate posts: the second is here and the third is here.
The Bank of Canada has been warning homeowners that low mortgage interest rates are not here to stay, and homeowners' financial planning should be based on higher rates in the future. This concern is also the reason why the Department of Finance has been tightening conditions on mortgages. We don't want to see a wave of houses being dumped on the market because highly-leveraged home owners were unable to renew their mortgages. Or worse: a wave of defaults as people find they can no longer make their payments after renewing at a higher rate.
Below the fold, I'll try to sketch out how changing mortgage interest rates have affected mortgage payments in the past, as well as the sorts of changes people should be preparing for.
One reaction to all these warnings might be to shrug and say "What's the big deal? Interest rates move around all the time. Who needs to be reminded of that?" It turns out that interest rates do move around, but the general trend in mortgage rates in the past 30 years is downward:
(Data source is Cansim Table 176-0043). The most striking feature of that graph is the spike in the early 1980s, an episode that those of us of a certain age remember vividly. But since then, people would have been forgiven for making their plans based on the assumption that mortgage rates have a downward trend, and that mortgages would usually be renewed at a lower rate than what the initial loan was made.
The next graph supposes that in a given month, someone had taken out a 25-year mortgage at the rate that was available five years previously, and is now taking out a 20-year mortgage at the current rate. What whould be the effect of the change in mortgage rates on the monthly payments?
Again, look at that spike in the early 1980s: people renewing their mortgages back then were looking at new payments that were up to 60% higher than what they had been. But since then, the mortgage payments have almost always been revised downward.
That example was for the case where the original mortgage was amortised over 25 years. But longer amortizations of up to 40 years were introduced during the last expansion, although the government has since been cutting back. For the sake of argument, let's suppose that the inital loan was made at an interest rate of 5.5%, which is where mortgage rates have been fluctuating since 2009. Here's what happens to mortgage payments when they are renewed at higher rates:
Change in monthly mortgage payments Term of initial mortgage New rate 25 years 30 years 35 years 40 years 5.5% 0% 0% 0% 0% 6.0% 4.0% 4.7% 5.4% 5.9% 6.5% 8.0% 9.5% 10.8% 12.0% 7.0% 12.1% 14.4% 16.4% 18.1% 7.5% 16.2% 19.3% 22.0% 24.3% 8.0% 20.4% 24.3% 27.7% 30.6%
Longer initial amortizations amplify the effect of mortgage rate increases. 40-year amorizations were eliminated in 2008, so with any luck, the last column will be moot. 35-year amorizations were eliminated in 2011, and the recent measure brought it back to 25 years.
In the next post, I'm going to deal with another important consideration: the effect of lower inflation on homeowners' leverage.
Worthwhile Canadian Initiative 
Before this gets jammed, I would post a link to a site on how Canadian mortgages work for our American readers. Canadian and American mortgages are not the same financial product at all, the details differ (sometimes greatly). Just so we are all on the same page.
three points:
1. debt/income is a critical measure besides the payment “shock.” Many canadians accelerate their mortgage and pay a bit more than required. A 20% increase in mortgage payments is probably not a big deal if one is paying 10% of income to the mortgage (then one goes from paying 10% of income to 12% of income). Conversely, if its 30% then one goes from 30% to 36%, a much bigger shock.
2. lending standards: good LTV. good LTV. good LTV. cant say it enough: initial mortgages should have plenty of cushion! to slow a “bubble,” ltv is the key.
3. interest rate rises are endogenous, in the sense that the monetary authority will not arbitrarily raise rates to 8%. They will raise rates just enough to choke off inflation (hopefully not to prick a “bubble,” see #2). How high they raise rates is a function of how sensitive the economy is to higher rates. If lots of people are highly sensitive to a rate climb, they will not hike them as far.
Cool graph. I can hardly think of a better way to show how changes in interest rates alter finances for homeowners. I wonder if you surveyed homeowners, how many you’d find were resilient to what level of change in interest rates. Do they expect interest rates to even maybe go up by more than a couple/few percent in the next five years?