By Dale Roberts on September 6, 2022
Estimated reading time: 10 minutes

Housing affordability: What happens when lower home prices take on higher borrowing costs?

By Dale Roberts on September 6, 2022
Estimated reading time: 10 minutes

Borrowing costs are increasing as Canada experiences the fastest drop in home prices since the 1980s. Have we reached a tipping point for affordability?

Exterior view of the upper floor of a home on a cloudy fall day

Photo by Erik Mclean from Pexels

Canadian home prices are falling. Borrowing costs are increasing at an incredible rate. It’s the battle royale of home ownership affordability: Will wannabe home owners benefit from the real estate market correction, or will their dreams be crushed by the rising mortgage costs that are causing it?

I believe that improved home ownership affordability is on the way, but that the “improvement” will likely be modest. To understand why, it helps to know how we got here and to consider what happens to the affordability equation as home prices go down and borrowing costs go up.

Inflation (not rates) is the biggest concern for central banks

Since March 2022, the Bank of Canada (BoC) has been raising interest rates in an effort to tame runaway inflation.

In June, inflation in Canada reached a 39-year high of 8.1% year-over-year, after decades of mostly low, stable and predictable inflation. It eased to 7.6% in July, but it remains well above the BoC’s target of 2% annual inflation.

That said, if central bankers can’t wrestle inflation to the ground, they will be forced to continue raising rates until inflation is tamed—regardless of the impact on home owners and buyers.

Inflation is driving the bus. Or, you could say, inflation holds all of the keys to affordability.

Our last experience with high inflation came in two waves during the 1970s and ’80s, and it peaked at 12.9% in 1981. That year, the BoC’s benchmark rate reached 20.78%. If you think mortgages are expensive right now, consider that, as of Sept. 6, 2022, the benchmark rate is 2.5%.

Home prices are falling fast

I’ve said for many months that it would not be hard to pop the Canadian real estate bubble. It was, and is, the most Bubblicious real estate bubble on the planet. Rates were kept too low for far too long.

Recent home buyers have what people in the poker world call “weak hands”—meaning they may soon give up on their recent purchase and decide to sell. Apparently, the weakest hands belong to real estate “investors,” who leveraged existing properties to take on more debt during the recent home-buying craze.

When home prices start to correct, it doesn’t take long for over-leveraged home owners and speculators to find themselves under water. That’s when you owe more on your house or condo than it’s actually worth, and it’s a reason some owners might be forced to sell.

After a strong COVID-inspired real estate run, prices are now in a free fall. After peaking at $816,720 in February 2022, the national average house price fell 18.5% to $665,850 in June. The average price fell again in July, settling at $629,971—nearly 22.9% below the peak.

Here’s a chart that shows the incredible real estate run-up. Keep in mind that the Canadian Real Estate Association (CREA) uses its own unique benchmark to calculate national prices.

Borrowing costs are increasing

When the BoC’s benchmark policy rate goes up, mortgage interest rate hikes are usually not far behind. For example, Canada’s prime rate—on which variable mortgage rates rest—increased to 4.7% from 3.7% the day after the BoC’s 1% interest rate hike on July 13, 2022.

From February to July 2022, variable interest rates (for mortgages with a 10% down payment) moved from 0.9% to 3.5%. Meanwhile, fixed rates moved from 2.59% to 4.34% over the same period, according to data from Ratehub.ca. (Note: MoneySense.ca and Ratehub.ca are both owned by Ratehub Inc.)

The following table shows the lowest five-year fixed and variable mortgage rates (assuming a 25-year amortization) available in most provinces at the end of each month between February and July 2022, based on Ratehub.ca data.

	5-year fixed rates		5-year variable rates
	With 10% down	With 20% down	With 10% down	With 20% down
February	2.59%	2.79%	0.90%	1.25%
March	3.04%	3.29%	1.15%	1.70%
April	3.59%	3.69%	1.90%	2.20%
May	3.94%	4.04%	1.90%	2.20%
June	4.79%	5.04%	2.50%	2.80%
July	4.34%	4.59%	3.50%	3.85%

As we can see, since February 2022, variable mortgage rates in Canada have risen 2.6 percentage points, which represents an increase of almost 300%! Fixed rates have climbed around 1.8 percentage points, which represents an increase of 65%.

What this means for affordability

As falling home prices take on higher rates in 2022, has home ownership become more affordable? Let’s take a look at the impact these two forces have had on monthly mortgage costs, which are a leading factor for affordability.

The following table represents two scenarios: home owners with a 10% down payment, and those with a 20% down payment. Mortgages with a 20% down payment generally have higher interest rates because they are not eligible for mortgage default insurance. However, a home owner who puts down less than 20% will have to account for the added insurance costs.

Thanks to Gina Athanasious, a RE/MAX real estate expert, for her help with the following calculations.

Month (with average home price)	5-year fixed (10% down)		5-year fixed (20% down)		5-year variable (10% down)		5-year variable (20% down)
	Rate	Payment	Rate	Payment	Rate	Payment	Rate	Payment
February ($816,720)	2.59%	$3,326	2.79%	$3,022	0.90%	$2,736	1.25%	$2,536
June ($665,850)	4.79%	$3,414	5.04%	$3,110	2.50%	$2,685	2.80%	$2,467
July ($629,971)	4.34%	$3,100	4.59%	$2,827	3.50%	$2,838	3.85%	$2,619

The scorecard shows that, from February to June, variable-rate costs improved modestly, with falling home prices outweighing higher interest rates. Redo the same calculations for the 2022 period of February to July, however, and we see that variable-rate costs worsened, with higher interest rates now outweighing the drop in home prices.

The opposite is true for fixed-rate mortgage costs. Those costs worsened between February and June but improved modestly between February and July. That said, head-to-head, variable rates seem to remain the more cost-effective option.

	Mortgage costs (Feb to June 2022)		Mortgage costs (Feb to July 2022)
Down payment	5-year fixed	5-year variable	5-year fixed	5-year variable
10%	Up $89 per month	Down $82 per month	Down $255 per month	Up $102 per month
20%	Up $88 per month	Down $70 per month	Down $195 per month	Up 82$ per month

Factoring in the mortgage stress test

The mortgage stress test, which sets a minimum qualifying rate for new mortgages, requires borrowers to prove they can handle their mortgage payment at the greater of 5.25% or their contract rate plus two percentage points.

With many variable rates now sitting at just north of 4%, many buyers are having to qualify for a mortgage at 6% or higher, rendering the 5.25% threshold essentially not applicable. And now that fixed mortgage rates have increased by two-thirds in just four months, many people applying for fixed-rate mortgages are facing stress-tested rates of around 7%, on average.

This, too, is putting downward pressure on the housing market.

James Laird, co-CEO of Ratehub Inc. and president of the mortgage lender CanWise (which is also owned by Ratehub Inc.), explains that generally, for every 1% that the stress test increases, a household qualifies for about 10% less mortgage. “Home prices will need to drop significantly in order to neutralize the effects that higher mortgage rates have on the stress test,” Laird shared in a statement. “Unless this happens, home affordability will continue to be impacted significantly by the current rising rate environment.”

The unfortunate reality might be that even if you’re personally comfortable with the mortgage payments on the home or condo you want, that does not mean you’ll pass the stress test—and qualify for a mortgage.

Athanasious reminds me that, in the aftermath of the real estate correction of the late 1980s, the Canadian banks were very stingy—they would not lend. The banks were more than picky about who got a mortgage in that economically troubled environment. The Canadian banks are known to be very conservative. And that’s what also makes them generally wonderful investments for stockholders.

The ideal scenario for wannabe home owners

The optimal condition would be a period of ongoing price correction within a recession or near-recession that triggers rate cuts and lowers borrowing costs. Of course, if you’re waiting to get into the market, you want home prices falling and borrowing costs falling, too.

As the data above shows, we have not yet reached that tipping point. Through the lens of mortgage costs, fixed-rate mortgages are marginally more affordable right now than they were at their peak in February 2022—the opposite is true of variable-rate mortgages.

I asked Athanasious whether or not we could see improved affordability in the future. She says:

“Optimal affordability will arrive when the government focuses on a way to increase supply in a meaningful way. It all depends what your definition of affordability is at the end of the day. What is a reasonable and sensible amount to spend on housing compared to income? As you can see, affordability has not really improved. Rate hikes haven’t changed that. For me, the gap between salary and prices is too big to have anything considered affordable.”

My guess is that improved affordability—from today—is on the way. We have the fastest falling home prices since the 1980s. Most economists predict that the BoC will hold or continue to cut rates in 2023. That said, the “improvement” in affordability will likely be modest. Home prices have dropped, and the overarching structural imbalance remains with new housing supply failing to meet the ongoing (and increasing) demand.

TD Bank’s and CIBC’s view is that at 3.25% the rate is restrictive, meaning it’s high enough to cool the economy and bring down inflation. They might move to that 3.25% rate and then step back and observe the data, to see if the downward momentum on the economy is enough to bring inflation to the 2% to 3% target. They don’t want to press too hard and send Canada into a deep recession. It’s where physics meets economics, as I wrote in a recent MoneySense column.

But predictions certainly can fail.

There is the possibility that rates could continue to increase over time, even during a real estate correction. That could happen if we can’t get inflation under control.

Also, consider that investors and home buyers are forward-thinking. They will try to jump into the markets as the potential for rate cuts hits the newswire. Real estate prices could start to recover before the rate cuts take place.

A favourable scenario of falling home prices and falling borrowing costs may present itself, but the shift will likely only be temporary, and it will be nearly impossible to time perfectly.

Buyers who are waiting for that home-ownership sweet spot should consider expanding their options on price and location—to just do what it takes to get in the market. Getting in can serve as a potential hedge against another real estate bull run (a.k.a. market silliness).

As with stock investing, home buyers won’t be able to time the markets. But I would suggest they start the bidding process the moment affordability presents itself and they can qualify for a mortgage. And, of course, they should also ensure the mortgage is well within their financial comfort zone.

As a home owner who has benefited from this crazy real estate bubble, I do hope that common sense comes calling, and that the “affordability doors” open themselves to everyone.

Dale Roberts is a regular contributor to MoneySense. A former investment advisor, he also helps Canadian investors find sensible low-fee investment options on his blog, Cut The Crap Investing.