The Bank of Canada may be at or nearing the end of rate hiking, but the impact of rising borrowing costs on Canadians has only just begun.
So say the team at TD Economics which predict that the debt service ratio will hit a record high by the second half of next year.
The Bank’s most recent hike in December raised its rate by 50 basis to 4.25 per cent. TD expects one more hike will take the policy rate to 4.5 per cent by the first quarter of 2023. It has been a steep climb since rates sat at 0.25 per cent at the beginning of this year.
“While interest rates have been rising since the start of this year, the impact on household’s bottom lines has only just begun, said the TD Economics report by James Marple, Rannella Billy-Ochieng and Ksenia Bushmeneva.
“Debt service costs rise with a lag as mortgages and loan payments are renewed at current market rates.”
New borrowers are already feeling the impact. Variable-rate mortgages have climbed in step with the Bank’s increases and fixed-rate mortgages have risen by more than 200 basis points, says the report.
During the pandemic the household debt service ratio of Canadians declined to 13.3 per cent of disposable income from a peak of 15 per cent in late 2019.
That ratio remained low in those years even though household debt grew by 16.5 per cent or 6.3 per cent annualized from the end of 2019. There are a few reasons for this, says TD.
First disposable income grew, almost as much as debt, bolstered by government pandemic aid and when that ended by wage growth. The second was the decline in the effective interest rate from 4.4 per cent in the last quarter of 2019 to 3.4 per cent in the first quarter of 2022, said TD. The effective interest rate is calculated by dividing total interest payments by total debt.
At the same time the average amortization of mortgage debt rose by just over half a year.
But that has changed. Canadians who piled on debt when it was cheap now have to contend with interest payments on debt that is more expensive, and could get even more so.
TD says that debt servicing costs will continue to climb as loans renew at higher rates or Canadians take on more debt at the current market rate. The effective interest rate has already risen from 3.4 per cent in the first quarter to 4.2 per cent in the third and, according to TD, is likely to rise further to more than 6 per cent in the first quarter of 2024.
Borrowers on variable rates with fixed payments will see their amortization extend further, but only to a point. Once they hit their so-called trigger rate, where payments are not longer covering any principal, they may have to increase their payments.
Meanwhile, up to 18 per cent of fixed-rate mortgages come up for renewal next year and borrowers looking to renew will be facing the highest interest rates in 20 years, said TD.
In the third quarter of this year, a borrower who took out a $500,000 mortgage in 2017 was paying $700 more a month on renewal, the report said.
Even with the expected sharp decrease in household borrowing over the next year as Canadians hunker down, debt service costs will rise.
TD estimates that the debt service ratio, which has already risen from 13.3 per cent of disposable income at the start of the year to 14 per cent by the third quarter, will likely rise another two percentage points to 16 per cent by the second half of next year, surpassing the pre-pandemic peak of 15 per cent.
One bright spot is the personal savings that Canadians accumulated during the pandemic, which could provide a cushion to rising debt costs. However, with interest rates expected to remain at higher levels over 2023, TD expects much of these savings will go to paying debt costs.