Tip of the Iceberg:

In early December, the Bank of Canada raised its key lending rate by 50 basis points (0.5 percentage points), bringing it to 4.25%. In its accompanying statement, the central bank signaled that, after 400 basis points in hikes since March, it is likely nearing the end of its rate hiking cycle. We expect the overnight rate to a peak at 4.5% in the first quarter of 2023.

Higher interest rates have already made their way to new borrowers. Variable rate mortgages have seen rates go up one-for-one with increases in the policy rate (see Text Box 1), while fixed rate mortgages have risen by over 200 basis points. Rising borrowing costs have slowed housing market activity, and some borrowers are already feeling the sting. As glaring as those changes have been, much of its impact on borrowers is yet to come.

As loans renew at a higher rates, debt servicing costs will continue to climb. Canadian households currently spend 14% of disposable income on principal and interest.¹ This figure will likely rise by another two percentage points to above 16% by the end of 2023 (Chart 1). 

The increase in debt service will be driven entirely by higher interest costs. Principal payments will fall relative to income, as overall borrowing slows and as qualifying households that have the room extend their amortization in order to minimize the increase in monthly payments. With debt payments eating up more income, households will have to reduce savings or curb spending elsewhere, weighing on Canadian economic growth. We anticipate both over the course of 2023, with spending growth stalling and the personal saving rate drifting lower. 

The Pandemic Helped Push Down the Household Debt Service Ratio

One of the consequences of the pandemic has been a notable decline in the household debt service ratio (DSR). After peaking at 15% of disposable income in late 2019, the DSR sat at 13.3% at the start of this year.  

The DSR fell and remained low throughout the pandemic even as household debt grew by a robust 16.5% (or 6.3% annualized) from the end of 2019. Three factors explain its descent.

The first contributing factor was brisk growth in disposable income, which increased by an almost equally strong 6.2% annualized over the same period. Government income supports were key to sustaining growth in disposable income early in the pandemic, but as they pulled back they were replaced with solid growth in nominal employee compensation.

The second factor was a decline in the effective interest rate on household debt (calculated by dividing total interest payments by total debt). The effective rate fell from 4.4% in the final quarter of 2019 to 3.4% in the first quarter of 2022. In fact, with only a few exceptions – when the Bank of Canada has tightened policy – the effective interest rate on household debt has been on a thirty-year decline (Chart 2). The pandemic accelerated this trend.

The final factor behind the decline in the DSR was an increase in the average amortization of mortgage debt, which rose by slightly over half a year.²  The impact of this lengthening in average amortization was small, however, subtracting just 0.2 percentage points from the DSR.

Debt Service Costs Will Rise Quickly from Here 

Even as the Bank of Canada approaches the end of its rate hiking cycle, the impact of higher rates on household finances is only just beginning. In the absence of a significant reversal in interest rates, the DSR will soar to a new record, peaking in the first quarter of 2024. 

Driving the increase, the effective interest rate on household debt will continue to rise as households renew their mortgages or take on new credit at the current market rate. It has already risen from an estimated 3.4% in the first quarter to 4.2% in the third. Based on the historical relationship with market interest rates, as well as the shift in the composition of mortgages toward variable rates (from below 20% to 35% of outstanding mortgages), the average effective rate on household debt is likely to rise further from its current rate of 4.2% to over 6% by the first quarter of 2024. Underneath this, the effective rate on mortgages is expected to rise one and a half percentage points, while the rate on non-mortgage credit is expected to rise by slightly over three percentage points.

Faced with higher borrowing costs, some households that are not at their maximum amortization of 30 years may choose to extend the length of their loans. For variable rate mortgage holders with fixed rate payments, amortization will increase automatically, though only up to a point. Once borrowers hit rates at which they are no longer covering any principal, they may have to raise their payments.³ 

At the same time, an estimated 13% to 18% of fixed rate mortgage holders will face renewal next year. For these borrowers, interest rate increases will be the highest in twenty years (Chart 3). While there is a high degree of uncertainty around average amortization, our analysis suggests an upper bound increase of one year by the end of 2023. Anything less than this and the DSR will rise by an even greater amount.

Debt service cost will rise despite a sharp slowdown in household borrowing over the next year. We expect household credit to slow to under 2% year-on-year by the end of next year, down from 7.4% in the third quarter of 2022. Mortgage credit growth will lead the slowdown, but consumer credit will also lose momentum as spending on durable items – such as appliances and furniture – slows and renovation activity eases off, reducing demand for home equity lines of credit.

Three quarters of variable mortgages have fixed payments that only increase if the interest portion of a mortgage is not covered.³ According to the Bank of Canada, only 6% of mortgage holders have a variable rate that automatically reprices with interest rates. Those families, and others with mortgage contracts up for renewal have been the first to face higher interest costs.