Economists have long been sounding the alarm about the impact that higher interest rates in Canada will have on consumers, who are among the most indebted groups in the world.
But a new report from a top Canadian bank says most consumers are in good shape and equipped to face the challenge of higher borrowing costs, because of the way the debt is structured.
“Not only are fundamentals strong, but the structure of household debt will shade many borrowers from the full impact of higher rates,” said the report released by CIBC Capital Markets on Thursday.
Economists Benjamin Tal and Royce Mendes argue the real surprise from rising rates will be how few consumers feel the “full sting” of rising borrowing costs in the coming year.
The Bank of Canada has raised interest rates by 25 basis points three times since July, taking the benchmark rate to 1.25 per cent, which is the highest level since 2009.
Markets are predicting there’s a greater than 70 per cent chance the central bank could hike rates again as early as May as it continues on the path to tightening monetary policy.
‘One-third of Canadian households are completely debt free.’– Royce Mendes, CIBC economist
Meanwhile, Canadian household debt hit a new record high in the third quarter of last year, with consumers owing $1.71 for every dollar of disposable income they had.
While CIBC has said in the past that elevated debt loads have made interest rate hikes almost 50 per cent “more potent” in comparison to the early 2000s, they now say new research shows that it will not be enough to “break consumers’ backs.”
“One-third of Canadian households are completely debt free, making higher interest rates a boon for them,” said Mendes. “This is both a blessing and curse, because that means that all of the debt held is by only two-thirds of the economy.”
“Of those with debt, two-thirds hold only non-mortgage credit, with the remaining having both mortgage and non-mortgage debt. Close to three-quarters of the dollar-value of all household debt is held in the form of mortgages, with consumer credit making up the rest,” he added.
Exposure to higher rates
For both mortgage and non-mortgage debt, the bank estimates that less than 20 per cent of the outstanding loans have been exposed to higher rates so far, but that could go higher.
The Conference Board of Canada says a minority of Canadians are ‘extremely leveraged’ at seven to 10 per cent of households. (Sean Kilpatrick/Canadian Press)
“On mortgages, the majority of non-fixed rate debt is variable, meaning that payments don’t change but amortization does,” said Mendes. “For fixed-rate mortgages, only about one-fifth will be resetting in any given year.”
He also pointed out that interest rates today for many fixed-rate mortgages is more or less the same as five years ago, so many borrowers whose rates are going reset will not feel the effects of higher rates.
“Furthermore, Canadian households actually began insulating themselves in 2017 to a greater degree by locking in borrowing rates rather than rolling over variable/adjustable rate mortgages,” he added.
Consumers ‘can cope’
The economists said higher interest rates alone will not be enough to rein in consumer spending.
But combined with a “deceleration” in job creation and the tighter availability of credit from the new mortgage rules, the economy will see a noticeable slowdown in household spending this year.
But Craig Alexander, economist at the Conference Board of Canada said in a note last month that only seven to 10 per cent of households — a minority in Canada — are “extremely leveraged.”
“This group, numbering more than one million households, is the one at risk from higher interest rates, but those in it should adapt if the increase in rates is slow,” he said.
The latest data show the debt-service ratio, which is loan payments as a share of after-tax income, at just less than 14 per cent, he said.
The debt burden for an individual household becomes severe when debt-service costs get close to 40 per cent of disposable income.
“At the economy-wide level, these data imply that households can cope with higher interest rates,” he added.