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The media is spending a lot of time talking about rising inflation and interest rates. It’s OK if you don’t understand what it all means…we’re here to help make sense of it – and what it means for the Toronto real estate market.
Inflation is a measure of how prices are changing over time. In Canada, the inflation rate is measured by the Consumer Price Index (CPI) which measures changes in the price of a typical basket of goods, including food, shelter, furnishings, clothing, transportation, health and personal care products, recreation and alcohol. Canada’s inflation rate has hovered between 1-3% for the last 20 years but has recently been accelerating, reaching 6.8% in April 2022, largely driven by increases in the price of food and shelter.
Why is inflation increasing?
Canada (and much of the world) is seeing rapid price increases right now because the flow of goods (in other words, the ‘supply chain’) has been interrupted due to overseas COVID lockdowns and the war in Ukraine, coupled with extremely high consumer demand for goods as we re-emerge from the pandemic (aka “revenge living”). High inflation is expected to continue to plague the Canadian economy for at least the rest of the year.
Governments don’t like it when the cost of living increases faster than wages – they like low and stable price growth. One of the fastest ways for them to control inflation is to encourage people to save money instead of spending it – and governments do that by increasing interest rates. Interest rates don’t just make mortgages and loans more expensive, it affects how much people are paid for saving their money in investment products like GICs (Guaranteed Investment Certificates) too. Case in point: my parents got a 5-year GIC last week at a 4% interest rate – WAY higher than the 1-2% banks have been offering for years.
What it means for Toronto real estate:
High inflation means we are spending more money to buy basics like gas and food, which means we all have less disposable income. Because household budgets are affected, some home buyers will be nervous about taking on new or bigger mortgages and may delay buying their first home or upgrading to a bigger one. And because the primary tool used to control inflation is interest rates, homebuyers will qualify for smaller mortgages than they did before and will have higher mortgage payments too.
Interest Rates 101
The Bank of Canada sets the overnight rate – the rate at which banks lend money to each other (which they then use to lend to consumers).
The prime rate is the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages and investments. That prime rate is based on changes to the Bank of Canada’s overnight rate.
The actual interest rates that consumers pay are tied to the prime rate and vary depending on a borrower’s solvency (ie credit rating and financial situation) and the bank’s goals (ie attract more mortgages or more investments).
Canadians have been enjoying low interest rates for years. Before the pandemic in March 2020, the Bank of Canada’s overnight rate was 1.25%. When COVID came to town, The federal government swiftly decreased the overnight rate to 0.25% to help our troubled economy, which led to substantially lower mortgage rates (as low as 1.5 to 2%) and spurred consumers to spend money during the pandemic. It’s one of the reasons Toronto’s real estate market has been bananas for the last 2 years.
In April 2022, in response to rising inflation, the Bank of Canada raised the rate by 0.5% (or what mortgage pros would call 50 “basis points”), from 0.5% to 1% – still lower than it was before COVID. We expect to see several more rate increases, including on Jun 1, 2022, where experts predict another 0.5-0.75% increase.
Prime rates at the end of April 2022 were 3.2% – still lower than the 3.95% we saw before the pandemic in 2020.
Let’s put interest rate hikes in perspective, in real dollars.
Picture it: You purchase a $1,000,000 home with a 20% downpayment and take out an $800,000 mortgage. Amortized over 25 years, here’s how fixed-rate mortgage payments vary depending on the interest rate:
|Interest Rate||Mortgage Payment|
How Do Rising Interest Rates Affect Home Buyers?
- Interest rate hikes increase monthly mortgage costs. A 0.25% interest rate hike translates to an extra $13 per month for every $100,000 of mortgage.
- The interest rate affects how much money you can borrow. Lenders have very strict rules about how much money they will lend, so higher interest rates result in lower purchasing power. Your bank may have been prepared to lend you $600,000 when interest rates were 2% – but at 4%, your maximum home budget will almost definitely decrease.
- Higher interest rates sometimes lead to increased Buyer activity. Aspiring homeowners with mortgage pre-approvals at lower-than-current rates are motivated to buy before their rate guarantee expires…and Buyers who expect higher interest rates in the future may choose to buy now while their carrying costs are lower.
- Higher interest rates sometimes lead to lower home prices, but they also lead to increased monthly costs. If you’re waiting for prices to fall before buying, be careful – it might end up costing you more over time.
Pro Tip: If you’re thinking of buying in the next 12 months, get pre-approved and locked into a mortgage rate NOW. Nobody expects interest rates to decrease anytime soon (but if they do, you’ll still get the lower rate). Most mortgage pre-approvals are valid for 90 days, so you’ll probably need to repeat this exercise every 90 days until you buy.
How Do Interest Rate Hikes Affect Sellers?
Past interest rate hikes in Toronto have resulted in increased short-term buying activity (usually for a month or two), as Buyers with locked-in rates from before the hike accelerate their purchasing timeline.
BUT….the biggest factor at play in Toronto’s real estate market right now is Buyer psychology, and that’s almost impossible to predict. If Buyers think rates will continue to increase, they may buy sooner rather than later to take advantage of today’s lower rates; but they might also see an interest rate hike as a red flag and decide to wait and hope that prices will come down.
How Does It Affect Home Owners?
If you’ve already got a mortgage, you might think interest rate hikes don’t affect you. Wrong! When you first got your mortgage, you made a few important decisions:
- Amortization Period (usually 25 years)
- Mortgage Term (usually between 1 and 5 years).
- Type of mortgage rate: Fixed or Variable
- Interest rate
At the end of your term, your mortgage will come up for renewal – meaning that you’ll be subject to the prevailing interest rates. If current interest rates are higher than your old rate, your monthly carrying costs will go up. If rates go up significantly, some people may not be able to afford their homes anymore. Thankfully, the federal government introduced a mortgage stress test a few years ago to ensure that homeowners would still be able to afford their homes even at much higher interest rates.
Variable Rate Mortgages
Most variable-rate mortgages have floating or adjustable payments, meaning that the amount of your mortgage payment changes with the bank’s prime interest rate, so rising interest rates result in higher mortgage payments.
If you have a fixed payment variable mortgage, where your payment doesn’t fluctuate with interest rates, the percentage of your mortgage payment that goes towards paying down the principal on your mortgage will decrease, which means that more of your payment will go towards paying interest than building equity and will increase how long it will take you to pay off your mortgage.
Most variable-rate mortgages have the option of converting to a fixed-rate (meaning your rate does not change for the length of your term, and so the payment won’t vary when interest rates change). Historically, variable-rate mortgages have been cheaper, but if you think interest rates are going to continue to increase at a fast pace, you may want to consider converting to a fixed-rate mortgage. Note: as of writing, our mortgage partners continue to recommend variable-rate mortgages over fixed because of the significantly favourable interest rates.
Pro Tip: Stop trying to time the market. I don’t have a crystal ball and neither do you. Do the right thing for you, whether that’s deciding to buy now, buying later, or deciding to sell.