Review: Bank of Canada Raises Interest Rates

Unless you were on vacation last week, you probably saw the news that the Bank of Canada increased interest rates.  A lot of commentary has followed the move with everyone sharing their opinion on the matter and what it means for the real estate market.  Today we are going to share our take ☺

What should I know about what the Bank of Canada did last week?

The Bank of Canada raised its overnight lending rate from 0.5% to 0.75% last week.  This overnight rate determines the rate at which banks lend money to each other on a regular basis.  This affects the bank’s cost of funds and since the banks lend to consumers based on a spread, this would lead to increased borrowing costs.  This is the first interest rate increase in seven years.

Why did the Bank of Canada raise interest rates?

The bank has 2 mandates:

1. To ensure the economy is operating as close as possible to full employment.

2. To ensure inflation is operating within an acceptable range (generally 1-3% annually).

The bank cited a strengthening economy and expectations for higher inflation as two primary reasons for the increase.  Another reason is that the Bank of Canada acts mindfully based on how the U.S. Federal Reserve acts. The U.S. has increased interest rates three times already this year!  Lastly, the Bank of Canada is concerned about runaway house prices in large markets such as Toronto and Vancouver; they want to reign in speculation and increased borrowing.

What does the interest rate increase mean for me?

The Big Banks in Canada set a prime lending rate based on their cost of funds.  For the last few years, this rate has been set at 2.7%.  Lots of borrowing products, including variable rate mortgages and home equity lines of credit, are based on a discount or premium based on the prime rate (ie. prime -0.50%).  Therefore, rates on variable rate mortgages and other products tied to prime rates will increase as a result.  In fact, the big banks had all increased their prime rate from 2.7% to 2.95% within 24 hours of Bank of Canada decision.  Fixed rate mortgages or loans (being fixed) will not see a change.

How will this interest rate increase affect the real estate market?

When looking at the big picture, this interest rate increase is very small.  Lets use an example to illustrate:

• The current average home price in Canada is approximately $500,000
• Suppose your mortgage is based on 80% loan to value or $400,000
• Let's say your variable mortgage is based on the previous prime rate of 2.7%
• Now your prime rate is set to increase to 2.95%
• The amortization period is 25 years
• Your previous payment was $1831.95/mth.  Your new payment is $1882.73/mth.  An increase of approximately $50/mth.

While $50 extra isn’t fun, we don’t see it breaking the bank in the big picture.  When people think about interest rate increases, they think about rates rising to historical averages of 7-10%.  We are nowhere near this.  It would take a long succession of interest rate increases for interest rates to really affect the market.

Before the rate increase, sales in markets like Toronto were pulling back on the heels of a proposed 15% foreign buyers tax.  Add chatter of increasing rates and all of the sudden people are sitting on the sidelines.  This seems to be more of a perception issue with people reading the headline news.  Prices were already sky high and speculators are pulling back.  It's doubtful that the extra 0.25% on borrowing costs is suddenly making it unaffordable for qualified buyers who were in the market looking already.

In our home market of Windsor, Ontario, with an average price of $267,000, the affordability is very good and therefore this interest rate increase shouldn’t affect demand too much.  Using the same example above, adjusted for our lower prices, we are talking about an increased payment of $27/mth.  Interest rates are still bouncing off a historical bottom and have a long way to go before affecting affordability.

What are your thoughts on this interest rate increase?