Bank Of Canada Interest Rate Hikes Affect Variable Mortgages As Trigger Rate Approaches
The reason why July’s jumbo rate hike is a big concern isn’t because rates are “so high now”. The target rate is currently at 2.5%, and so just in the middle of the Bank of Canada’s neutral rate range between 2% and 3%.
But the pace of increase is a lot faster than normal, so that’s the big concern for home owners who have already been stretched too thin at low rates, who are now are faced with both rising costs of living plus rising mortgage payments because variable mortgages are now approaching something called the trigger rate.
Let’s dive into what these changes mean for Toronto real estate.
How Rate Hikes Affect Variable Mortgages
If you look at the latest June data, you can see that in Toronto, listings have actually come down compared to the same month last year, and that’s helping to give support to the 416 market. Sellers know that real estate prices are coming down, and so if they don’t need to sell, they probably won’t.
And they can do this because they haven’t felt the full impact of interest rate hikes yet, even for variable mortgages. When you get into a variable mortgage with the big banks, your monthly payments are usually fixed based on the rate you get in at.
For example, if you got in when variable rates were at 1.75%, then the monthly payments will be calculated based on that rate and you’d be paying $3,400 per month for a $1.2M property with a 20% downpayment and 30 year amortization.
Then if interest rates go up, the monthly payment might still stay the same. What happens is that the interest portion will go up and the principal portion will go down, as long as interest payments don’t exceed the fixed monthly payment of $3,400 per month, which is what most home owners are still experiencing.
But rates have come up by 2.25% already, and any more might mean monthly payments will start coming up. If we end up seeing another two more rate hikes after that by year end, that same home owner with the $3,400 original mortgage payment might have to pay an extra $700 each month. And this will certainly weaken holding power, and those who have been stretched too thin even before the hikes started might be forced to sell at potentially much lower prices.
How Does This Affect Stress Tests?
For most of us who have to buy with a mortgage, our buying power will be reduced because stress tests are starting to get harder than before. In simple terms, we’ll be looking at around 16% less purchasing power from the mortgage side once variable rates get to 5.25% possibly by the end of this year. We can also look at it another way.
How Does This Affect Holding Power For Investment Houses?
Even if a buyer doesn’t run into mortgage qualification issues, they will still be affected by higher borrowing costs when variable rates get to 5.25%. For those who invest in houses in Toronto and are looking for positive cash flows, prices would have to drop 25% from peak prices to maintain the same cash flows, even if we factor in an increase in rents over recent months.
It’s now also possible that more and more investors will start to become comfortable with break-even cash flows when interest rates peak, as long as the purchase price is right. Most investors make numbers-based decisions, and so they might take the view that interest rates are cyclical and are okay with higher cash flows because they know cash flows will improve once rates come back down. Now if an investor ends up being OK with break-even cash flows, this means 416 prices for investment houses don’t need to drop that much at 18% from peak prices.
How Does This Affect Holding Power For Investment Condos?
The upside here is that rents for condos in Toronto have increased a lot more compared to houses in the past few months. Just note that at the same time, condo cash flow is negative, and there’s not much room for more negative cash flow. So, even with faster growing rents on the condo side, we might still see a 21% drop from the peak for condo investments in Toronto.
Toronto Real Estate Forecast
If we bring it all together, here’s where we might be at. For end-user properties, which have already dropped 21% in the suburbs and 16% in core Toronto, there’s probably still a long way to go if we expect purchasing power to drop by 16% by year end, or more if it overcorrects.
Will we actually see prices drop by that much? Well, I think that depends on the home owner’s holding power. In the suburbs, 905 detached home prices shot up 70% over COVID, so I’d say a lot of those home owners are stretched pretty thin and we’ll probably see a lot more of those home owners forced to sell at lower prices.
Investment houses have come down 13% in the 416. If we expect a 18 to 25% price drop from the peak, the best case might be a 5% drop, but it’s just as possible to see bigger 12% declines. Finally, Toronto condos have already come down 7%. So if there’s going to be a 21% total drop from the peak, then we might see another 14% drop in the Toronto condo market too.
And one final note on timing. We think investment property prices are going to come down quickly, even before interest rates actually hike, because more and more investors are future-proofing their buying decisions with future projected peak interest rates.
End-user home price drops, on the other hand, might lag and follow interest rate hikes. So this means if you’re looking to buy or invest in real estate, keep a close eye on the market over the summer!
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