The Bank of Canada considers households that spend more than 25 per cent of their income on debt servicing to be more vulnerable to rising interest rates or a loss of income.DARRYL DYCK/The Canadian Press
A growing share of Canadians are spending a worryingly high proportion of their earnings on mortgage payments, according to new Bank of Canada data, a potential sign of stress on borrowers.
The central bank considers households that spend more than 25 per cent of their income on debt servicing to be more vulnerable to rising interest rates or a loss of income. The proportion of new mortgages that met this definition rose to 29 per cent in the fourth quarter, according to data published Friday.
That’s up from 12 per cent in the same quarter in 2021, and 14 per cent in the fourth quarter of 2019.
“A household that spends a large portion of its income on mortgage payments may be more vulnerable to financial stress,” the bank said in a report that tracks financial vulnerabilities such as the debt service ratio, which is the share of income used to service debt.
The report also showed that highly indebted households were falling behind on their payments for car loans, credit cards and lines of credit, though the overall percentage was just 2.16 per cent for the fourth quarter of last year. That is higher than in the fourth quarter of 2021, but lower than prior to the start of the COVID-19 pandemic, when 2.47 per cent of those households were at least 60 days behind on their payments.
However, the report also showed that the arrears rate for mortgage payments had declined over the past year even though interest rates were skyrocketing. This could be a sign that many homeowners have not immediately felt the effects of the higher interest rates because they have fixed monthly mortgage payments, or that homeowners are so far coping with their rising debt service costs.
“While the share of indebted households behind on their payments remains below pre-COVID averages, the data suggests that might not hold true for very long. Indeed, rates of other loans in arrears are already rising,” Royce Mendes, an economist and head of macro strategy at Desjardins Capital Markets, said in a note to clients.
At the same time, the data show that highly-leveraged borrowers are on the decline. The share of households taking out mortgages that are 4.5 times greater than their annual income or more dropped over the past year.
Borrowers have had to deal with the Bank of Canada pushing up its overnight lending rate by 4.25 percentage points in less than a year. Those increases immediately make it more expensive for any borrower with a variable-rate mortgage, which is tied to the central bank’s benchmark interest rate.
But because the bulk of variable-rate mortgages have a fixed monthly payment, many of those borrowers have not yet had to increase their monthly payment. Instead, with every interest rate hike, more of their payment goes toward the interest and less toward reducing the original size of the loan. That, in turn, extends the amortization period, or the length of time it takes to pay off the loan.
Major Canadian lenders reported that greater shares of their residential loan portfolios have amortization periods of more than 30 years as of January. A year ago, when the Bank of Canada’s benchmark interest rate was still 0.25 per cent, amortization periods remained below 30 years.
So far, lenders and the Bank of Canada have said that these borrowers represent a tiny part of the mortgage market, suggesting that they will not have significant impact on lenders’ bottom lines or the rest of the financial system and economy.
“That is a segment of economy that we watch closely. It’s always important to keep in perspective the size of that segment,” Bank of Canada senior deputy governor Carolyn Rogers said at a news conference this week.
The Bank of Canada held its benchmark interest rate steady at 4.5 per cent this week – a turning point after eight consecutive rate hikes. That made it the first major central bank to pause monetary policy tightening.
High household debt levels and relatively short mortgage terms make Canada more sensitive to rising borrowing costs than the United States, where 30-year mortgages are common and household debt levels are lower. That’s one reason the Bank of Canada paused its rate-hike campaign this week, even as U.S. Federal Reserve officials have said they intend to increase interest rates several more times.
Rate hikes work in large part by making it more expensive for homeowners to service their debts, leaving them with less money for discretionary spending. The central bank is intentionally squeezing Canadians’ finances to lower demand for goods and services, and thereby slow the speed of inflation.
While Bank of Canada is now in a holding pattern, officials say they are prepared to raise interest rates again if inflation and economic growth don’t ease as much as expected in the coming months.