With rate hikes underway in Canada, debt servicing costs are set to rise for households already contending with high inflation. Anthony Okolie speaks with Ksenia Bushmeneva, Economist, TD Bank, on the implications higher rates will have on Canadians’ appetite for new credit.
Originally published May 9, 2022
- That's right, Anthony. So in fact, Canadian household debt is about 12% higher than it was prior to the pandemic. And the main reason for that is the run-up in mortgage credit. So as interest rates declined and as households seek to reshuffle their living arrangements with the arrival of the pandemic, they really binged on the mortgage credit. And that led to a significant increase in the overall household debt.
And what's important is that the household debt is not only higher in nominal terms. It's also higher relative to disposable income, so relative to the amount of money that households make net of taxes, which right now is at about 186% of disposable income.
- Now, you also said that the composition of debt has also changed during the pandemic. How so?
- That's right. So as I mentioned, households really binged on mortgage credit. But at the same time, consumer credit balances have actually declined during the pandemic. So households paid down their credit cards and their lines of credit, sometimes via a debt consolidation, as they kind of lumped it all into their renewed mortgages. So that led to households holding more mortgage credit, but actually less consumer credit.
- OK, let's talk about the impact of higher rates on the different types of credit. Let's start with the least impacted, auto loans and credit cards.
- Yeah. So with interest rates going higher, many of the credit products will be affected, particularly with the products tied to the prime rate. So credit cards are actually least affected by the Bank of Canada interest rate increases. So from that standpoint, those payments are not going to be affected by the interest rate environment. Interest rates on auto loans have already come up quite a bit. And there's probably room for them to increase further, but not to a great extent.
- What about mortgages for first-time homebuyers?
- I would say that households looking to buy a house would be the most affected by higher interest rates. And in fact, they are being impacted on two sides, right, from high interest rates, but also from higher home prices, which we know have jumped quite significantly in the first quarter of this year. So there is this double whammy.
We've done some estimation, and our calculations suggest that households looking to buy a home at the end of this year would be looking at about $700 more in monthly payments than what they would have been paying if they bought a house at the end of last year. So that's definitely a very meaningful and significant increase for them.
- OK, let's look at home equity lines of credit, or HELOCs, which have really gained in popularity among many Canadians. What are the risks to borrowers?
- Mhm. Yes, that's right. So there's been quite a strong demand for home equity lines of credit during the pandemic, which tend to go hand in hand with a higher demand for mortgages, as well. And it's a little bit more difficult to assess the impact of higher interest rates on home equity lines of credit because they tend to come in two forms, the revolving lines of credit, which are going to be impacted by increases in the prime rate and increases in the Bank of Canada rate. And some borrowers have it as an amortizing product, which means they're exposed to fixed rates, and payments might be more predictable. And they're also amortized over time, which makes it, I guess, better for the borrower because they tend to pay down their debt over time.
And we know that, during the pandemic, the popularity of the amortizing types of home equity lines of credit has increased. So that's good because it means a larger share of HELOC borrowers have more predictable and fixed monthly payments. But at the same time, we also know that still about 60% of HELOC debt is being held as revolving debt, which means that there's still a significant portion of those borrowers that are going to be exposed to increases in the Bank of Canada rate.
- And finally, compare variable versus fixed mortgages. What are the impacts there?
- So I think both types of borrowers are going to be impacted. For fixed rate borrowers, the impact is going to be slightly more gradual, and will really depend on the year that they took out their mortgage and what the interest rate has been at the year when this mortgage has been originated. So this year, I think they could see an increase in their borrowing costs of about 75 basis points or higher, those borrowers that are renewing at a five-year fixed rate. But for example, next year the increase could be much less because borrowers that originated in 2018 have already been exposed to higher interest rates at that point.
For variable rate borrowers, many of those mortgage payments are actually held fixed. Even as interest rates increases, their monthly payment doesn't tend to change. It just means that they're going to be paying less of the principal and more of the interest throughout the month or throughout the year. So from that standpoint, it's good news for them because they're not going to necessarily feel the increase in the Bank of Canada rate right away. But it also means that they're going to be paying down their mortgages at a slower pace than otherwise they would.
- What about inflation, which is currently hovering at 30-year highs? What impact could this have on Canadian household debt and income?
- Well, I think ultimately inflation is just another hurdle that households are going to experience this year and just another headwind to their finances, together with higher interest rates. And inflation also affects the Bank of Canada decision from the standpoint of how quickly they hike the overnight rate. So if inflation continues to surprise on the upside, that could also accelerate the rate hikes by the Bank of Canada. So really, I would say those are the main channels how inflation is going to be affecting households.
- What's your outlook on the Canadian household debt for this year?
- Overall, we expect that the household debt growth will begin to slow on the back of slowing demand for mortgage credit and slowing home purchases because, again, higher interest rates are going to make it more expensive for Canadians to buy a house, which has already been very quite unaffordable to start with. So it's just going to be an extra hurdle to homeownership. So because the mortgage credit will be slowing, the overall growth in household debt is expected to slow, even though consumer credit might see some recovery as households resume familiar activities, such as traveling and dining out, and spending on services picks up.
So there's kind of going to be these two opposing forces on mortgage credit and consumer credit. But because mortgage credit is such a big chunk of overall household debt, growth in household debt is expected to slow, more in line with disposable income. And so this debt to disposable income is actually going to moderate a little bit in the coming quarters.
- Ksenia, thank you very much for joining us.
- You're very welcome, Anthony.