Are rising interest rates the new normal? Since the early 1990s, the Bank of Canada have been steadily dropping their benchmark interest rate. But due to rising inflation, this period of lowering rates seems to be at its end.
In this article, we’ll explain why the Bank of Canada increased their key policy rate, and how higher interest rates will impact your mortgage in 2022.
Table of Contents
Will Rising Interest Rates Cool Canada’s Housing Market?
Best answer: It’s complicated.
For anyone hoping raised rates may finally cool Canada’s red-hot housing market, don’t get too excited yet.
To understand why, let’s break-down the two components of your mortgage rate:
- Principal
- The amount you borrowed from your lender to pay for your home.
- Interest
- The additional amount of money charged to you by your bank as payment for lending you money.
How your lender calculates mortgage interest rates depends on the type of mortgage you get.
The prime lending rate anchors a variable-rate mortgage, while the Canadian bond market influences a fixed-rate mortgage. We’ll explore each of these later in this article.
Why Are Canadian Mortgage Rates Going Up in 2022?
Some Canadians are seeing rising mortgage rates because the the Bank of Canada is raising their key policy rate. We’ll explore what that is deeper into this article, but for now you can think of it as the minimum interest major banks pay when they borrow money.
In April of 2022, the Bank of Canada increased their key policy rate by 50 basis points (half a percentage point). This is after dropping their rate to historic lows in an attempt to keep the fragile 2020 economy from tanking into a recession.
However, the bank signalled they will continue raising their interest rate higher than the 1.75% it was prior to 2020. In fact, economists predict Canada’s central bank will raise it in increments every quarter through to 2023.
Why Did the Bank of Canada Lift the Rate Half a Percentage Point?
What causes interest rates on mortgages to rise is, simply put, the high inflation rate.
The Bank of Canada has the same mandate as America’s central bank; the Federal Reserve. What they do is closely monitor economic factors in Canada to shape a monetary policy. Their goal is to keep inflation as consistent as possible to prevent an economic slowdown.
Inflation usually happens when demand for goods and services outpaces the supply. A sudden increase in demand, or decrease in supply, means higher prices.
Although a small but steady rise in the price of goods and services is normal, a sharp increase is not.
The BoC’s main tool to combat a rapid rise in inflation is increasing their key policy rate. This rate is also known as the overnight benchmark interest rate. In the US, it’s called the federal funds rate.
What is the Overnight Benchmark Rate?
A bank’s balance sheets don’t always break even at the end of each business day. As a result, they borrow money from other banks, or the central bank.
Because it’s only major financial institutions borrowing this money, the Bank of Canada sets the interest rates to be as low as possible. This means the overnight benchmark rate carries less interest than any other loan.
That is why this rate is known as the benchmark rate, as it sets the minimum interest banks need to charge if they still want to profit. This minimum rate charged by the major banks to their best customers is called their prime lending rate.
How Does the Bank of Canada Control Inflation?
This is where that benchmark interest rate comes in:
- The Bank of Canada raises their interest rate. This makes it more expensive for major banks to balance their books at the end of each business day.
- Major banks have to raise their minimum interest rates in order to pay for the higher cost of a loan.
- Higher interest rates discourage people from taking out loans. This should lower the demand to buy goods and services.
…And lower demand should mean slower inflation!
So now that we know why interest rates are increasing, let’s see how it affects mortgage rates…
How Do Rising Rates Affect Your Mortgage?
As mentioned earlier, the way banks calculate mortgage interest rates depends on your type of mortgage.
Fixed-Rate Mortgage
With fixed mortgage rates, your interest rate is tied to the bond market. Treasury bonds come with the guarantee governments repay them over a specific term length. Therefore, banks consider them to be very low-risk investments.
Not to mention, the Canada bond market thinks and acts slower than other financial markets, so bond rates tend to be more stable long-term — even if the economy sours.
The key takeaway? Bonds are issued with term lengths. This means the interest you pay will stay the same for the entire span of your mortgage term. Rising rates would only affect your monthly payments when you renew your mortgage for its next term.
Bottomline: Higher interest rates won’t affect your mortgage rate until the start of your next term.
Variable-Rate Mortgage
In contrast, the interest rate on these mortgages is not locked during the term.
Instead, the rate is tied to your bank’s prime lending rate. And remember, the prime lending rate is tied to the Bank of Canada’s overnight benchmark interest rate.
This means interest costs can go up and down over the term depending on the actions of the Bank of Canada. If the BoC hike rates, major banks will quickly raise their prime lending rates. As soon as prime lending rates rise, the interest on variable mortgage rates rise too.
With that said, rate hikes from the central bank don’t always mean a higher monthly payment. Often, variable rate mortgages keep your mortgage payments the same. Your payments will just put a larger percentage towards the interest than the principal.
If you have an Adjustable-Rate Mortgage however, rising rates will mean a larger monthly payment.
Bottomline: Higher interest rates will affect your mortgage payments. You’ll either be paying more towards interest than principal, or you’ll have to make larger payments.
What Happens to Mortgages When Interest Goes Up?
…So will the price of a home go down in Canada? Well this is why it’s a bit complicated. You see, Canadian home values might go down… but they also might not.
Here’s why:
Could House Prices Drop?
Higher interest means people are less likely to take out a mortgage. Less demand forces home sellers to charge less money.
In other words, homes may have smaller price tags.
What Would Keep Homes Expensive?
Yes this is obvious, but when interest rates go up, you pay more interest. That means even though the price tag of a home may go down, the actual money you pay your bank might not.
How Will This End?
The goal of the central bank is to slow down economic growth just enough to avoid rapid inflation, but not enough to cause a recession.
In short, it’s a delicate balancing act which can end one of two ways:
Best Case Scenario: Soft Landing
The economy avoids a severe downturn in what the Bank of Canada refers to as a soft landing. Financial markets stabilize and certainty returns to Canada’s economic outlook.
Worst Case Scenario: Hard Landing
In what’s known as a hard landing, the central bank over-compensates, and the economy plunges into a recession. This could happen if other factors putting pressure on the economy were more impactful than previously anticipated.
Uncertainty surrounding the aging workforce, disruptions in the supply chain, and growing household debt could be factors that complicate Canada’s future financial situation.
How Much Will Interest Rates Go Up in Canada?
The Bank of Canada has signalled they will keep raising their interest rate in increments of 25 to 50 basis points (0.25% – 0.5%) until the end of 2023.
Keep in mind, this is the rate major Canadian banks pay to borrow money. Since your bank wants to earn a profit, the rate you end up paying for your mortgage will be higher.
When Will Mortgage Interest Rates Go Down?
Of course, the interest rate won’t keep going up. With that said, it’s tough to know exactly when it will drop again.
It all depends on inflation and the economy at large. If the BoC over-compensates, and the economy begins to tank, they’ll likely lower their bank rate to stimulate growth.
On the other hand, short-term interest rates will likely stabilize if they achieve a soft landing.
Will Home Prices Fall in the Next 5 Years?
For home buyers checking the mortgage interest rates forecast for sunny weather… perhaps pack an umbrella!
Even if home prices fall, mortgage rates could remain the same due to rising interest.
In other words, even if you pay a lower principal or closing costs on your mortgage, you might pay higher interest overall. This means your average rate may stay the same in the near future.
Not to mention, slow economies build less homes. That lack of supply will continue to put upward pressure on current mortgage rates.
…So Should You Wait to Lock in a Mortgage Rate?
Interest rates won’t remain low, but don’t let that stop you from buying a house if you’re ready to do so.
It’s tough to make accurate mortgage rate predictions given the many variables that push rates higher in the Canadian housing market.
With that said, since the benchmark rate is likely to keep going up until at least the end of next year, getting a fixed mortgage rate may be wiser than a variable rate.
But at the end of the day, major financial decisions like buying a home are up to you, your family, and no one else.
So when’s the best time to buy a house? When you and your family are ready, and an adequate house you can afford is available!
Conclusion
- Mortgage rates are made up of principal and interest
- The Bank of Canada leverages rising interest rates to combat rapid inflation
- Major Canadian banks have to raise their prime lending rates to avoid lost revenue when borrowing from the central bank
- Fixed mortgage rates WON’T be immediately affected by rising interest
- Variable rate mortgages WILL be affected by a rate hike
- It’s not known if higher interest will lower home prices
- This will end in either a Soft Landing, or a Hard Landing according to the Bank of Canada
- Rates may continue to rise in the near future
Your Future Doesn’t Have to be Completely Unpredictable…
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