Canadians with loans and mortgages tied to the Bank of Canada’s prime rate may be considering their options after the central bank raised its key interest rate by a quarter of a percentage point to 4.75 per cent Wednesday.
The rate increase, a reaction to stronger-than-expected economic data showing inflation now sits above four per cent, could be a sign of things to come.
“If the data don’t improve, I think certainly the rates could remain higher for longer,” said Derek Burleton, deputy chief economist with TD.
Ahead of Wednesday’s rate hike, Burleton said he wouldn’t be surprised if the bank increased or held steady and that regardless the bank would be firing a “warning shot” that Canadians should prepare in case the numbers suggest the economy isn’t slowing down.
Robert Kavcic, senior economist with the Bank of Montreal, added that he expected the bank to at the minimum “start talking pretty tough” about getting aggressive with interest rates to cool the economy off.
“This pause [in rate hikes] has always been conditional and it’s looking like it may very well have to be conditional because inflation isn’t really breaking and the economy is still pretty solid,” he said. “They might actually have to turn around and start raising rates again in the summer.”
As it happens, the bank opted to do more than talk Wednesday, and increased the rate for the first time since January, when the bank signalled it would pause its rate increases that started in March last year.
The goal behind rate hikes is to slow spending to the point the economy grows at a targeted two per cent.
That’s done by the central bank increasing the borrowing costs for other banks, who in turn make it more expensive for both businesses and households to borrow.
The theory is when it’s more expensive to borrow people will spend less and the price of goods will rise more slowly.
Kavcic said the rate hikes last year were effective in bringing inflation down from a peak of about eight per cent to the current level of four.
“The economy has slowed down and you’re starting to see signs across sectors that the economy is off the boil,” he said. “But we’re still kind of running with four per cent underlying inflation, which is a little hot for the Bank of Canada.”
Wednesday’s rate hike will affect everyone differently.
Most notably those with variable rate mortgages, loans and lines of credit that are tied to the central bank’s prime lending rate, could face higher payments and may be considering a switch to fixed-rate mortgages that lock in a rate for a set term.
Victoria mortgage broker Scott Travelbea said everyone is different and their personal circumstances will determine how they react to the rate hike.
“We’re in a unique time where a fixed rate is lower than a variable rate, so we are working with people to refinance and stretch their mortgages out over a longer period of time to bring down the payments and doing shorter terms,” he said, adding he is doing a lot of one- to three-year terms at a fixed rate for those who are on the brink of mortgage renewal.
There may be some homeowners with variable rates wanting to lock into a fixed rate so they are guaranteed to know their costs, regardless of what the central bank does from here on out. Usually that can be done by paying a penalty of three months’ interest.
The danger of locking in is paying more interest than needed if economic circumstances change and the rates start dropping.
James Laird, chief executive of Ratehub.ca, said the rate hike will mean even borrowers who have fixed payments with their variable-rate mortgage will likely exceed their mortgage’s trigger rate — the point at which the payment doesn’t cover the interest accrued since the last payment and the entire mortgage payment is going to interest and not to the principal.
That means their payments will increase as well.
According to Ratehub, a homeowner who put a 10 per cent down payment on a $992,861 home with a 5-year variable rate of 5.55 per cent amortized over 25 years will see their monthly mortgage payment increase by $135 to $5,785.
As for refinancing debt, Travelbea said that market has slowed considerably in the current higher interest rate environment.
“Either people have an existing rate that they don’t want to get rid of, so they’ll be holding higher levels of personal debt, or they have a higher payment and they’re just getting through it right now,” he said.
He said there are others who do want to refinance but no longer qualify as a result of the new lending rates.
Travelbea said the Bank of Canada has over-steered to try to slow things down.
“We will get back in the centre lane, but it’s going to take some time,” he said.
Kavcic said it can take years for the effects of rate hikes to be felt in the economy.
“The most aggressive part of the tightening cycle was last summer, and we’re not even quite at the one-year anniversary of when the Bank of Canada really started to turn the screws on the economy and the academics will tell you that it could be 12 to 18 months before those rate hikes fully bite,” he said.
There are other factors at play in keeping inflation above the bank’s two per cent target.
Kavcic said there was a big buffer built into the economy through the pandemic as people weren’t spending and had savings built up to spend now, all the while the demand for workers remained high.
“Some of those factors may be making us wait a little bit longer for these [rate hikes] to actually work,” he said.
Economists agree the central bank is well aware that a number of Canadians have variable rate mortgages and hold their breath when these announcements are made.
“They are mindful that lot of Canadians did take out variable rate mortgages at the height of the housing boom, and I think it’s one of the reasons why they actually stepped back and paused [rate hikes],” said Kavcic. “They know they’re probably at some point going to lean pretty hard against a pretty big chunk of borrowers out there.”
Bryan Yu, chief economist with Credit 1, said unfortunately for some borrowers, the central bank is limited in how it attacks inflation.
“The reality is that they have only a number of tools available to them in order to do this on the monetary policy side. In this case, it’s the rates, and it’s a blunt tool,” he said. “It has a broad impact in slowing consumer spending, slowing household debt formation as well as just general housing demand.”
Burleton said the bank still has a lot of “wood to chop” to trim inflation to its target, but he does believe the country is close to the interest rate peak.
“I think the bigger question and the bigger uncertainty is the timing and extent of rate cuts in 2024,” he said. “I think the forecast has been pretty ambitious about anticipating a reversal back to 2.5 or 3 next year.”
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