What higher interest rates mean for real estate, debt and the economy

Canadians have come to expect ever cheaper debt. An interest rate hike this week would mark the reversal of that trend.

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A construction worker shingles the roof of a new home in a development in Ottawa on Monday, July 6, 2015. Experts say measures introduced by the Ontario government to cool the red-hot housing market are likely to leave a lot of the buyers on the sidelines as they await to see the impact of the changes. THE CANADIAN PRESS/Sean Kilpatrick

A construction worker shingles the roof of a new home in a development in Ottawa on Monday, July 6, 2015. Experts say measures introduced by the Ontario government to cool the red-hot housing market are likely to leave a lot of the buyers on the sidelines as they await to see the impact of the changes. THE CANADIAN PRESS/Sean Kilpatrick

Announcements from the Bank of Canada are rarely something to get excited about, but this Wednesday is shaping up to be different. For the first time in seven years, the central bank could actually raise interest rates. Officials have strongly signalled over the past couple of weeks that a hike is coming on the back of positive economic data. For many economists, an increase is a foregone conclusion, and the bigger question is whether governor Stephen Poloz signals more tightening is on the agenda.

A single increase in the overnight rate from 0.5 per cent to 0.75 per cent is not going to radically change the economy and household finances, but it would be more than just symbolically significant.  Many Canadians have become accustomed to cheap debt—mortgage rates, for example, have been falling since the 1980s—and the next few years could see a reversal of that trend.

“We’re clearly at a tipping point, not just in the Canadian economy, but in the global economy, where we need to acknowledge that rates will steadily climb over the next several years,” says Frances Donald, senior economist with Manulife Asset Management. “This Bank of Canada meeting represents the first step toward a higher rate environment.”

READ MORE: 6 charts that show why interest rates are about to rise

Here’s how that will play out in a few key ways.

Growth in household debt will slow

One number has probably generated more economic headlines and hysteria than any other: the household debt-to-income ratio. As of the first quarter of this year, Canadians owed $1.67 for every dollar of disposable income earned. (A decade ago, it was $1.39 for every dollar earned.) One recent study found that Canadian households and companies are piling up debt faster than any other developed nation in the world, adding $1 trillion since 2011. A dubious honour, to be sure.

The increase has been driven by historically low interest rates. Naturally, an uptick in the cost of borrowing should dissuade Canadians from taking on debt at such a fast pace. There are already signs the debt-to-income ratio has peaked (it ever-so-slightly decreased in the last quarter, for example) and a rate hike could cause it to slow further or flatline.

READ MORE: Drowning in debt is the new normal in Canada

Anything to prevent Canadians from becoming even more indebted should be a good thing. But debt-fuelled spending has helped boost the economy since the financial crisis. If households cut back, won’t the economy suffer? Not necessarily. “The only reason the Bank of Canada would even entertain raising interest rates at this point is because the economy is strong enough to sustain it,” says Beata Caranci, chief economist at TD Bank Financial Group. GDP is growing at a very healthy annualized rate of 3.7 per cent, she points out, adding that other sectors are starting to pick up the slack from the country’s juggernaut of a real estate industry.

Canadians will pay more to service debt

Households have been able to take on so much debt because the monthly cost to pay it down has been fairly low and stable. As a result, the debt service ratio (which measures the costs to pay down loans compared to disposable income) has bounced around 14 per cent for the past decade.

That will change if the Bank of Canada raises its benchmark rate, driving up the cost of loans of all kinds. The Parliamentary Budget Office recently estimated the debt service ratio will increase to more than 16 per cent over the next few years, warning that the “financial vulnerability of the average Canadian household would rise to levels beyond historical experience.” It’s an open question how some Canadians will cope with higher payments. “Some households might not be able to afford an increase,” Donald says. “And this where we can see defaults, first on auto loans and then on housing.”

READ MORE: A flabby core makes the Bank of Canada’s interest rate decision tough

If Canadians are paying more to service debt, they’ll also have less money to spend, which could weigh on the economy. That’s part of the reason why economists anticipate the Bank of Canada will tighten gradually and allow households time to adjust.

Mortgage rates are going up

In fact, mortgage rates are already increasing. RBC hiked its fixed mortgage rates by 20 basis points last week, and both BMO and CIBC made similar moves over the weekend. Most Canadians opt for fixed mortgages so these households with existing mortgages won’t be affected immediately. Even those refinancing a fixed mortgage in the next little while will likely still score a lower rate than five years ago.

READ MORE: Canadians are borrowing their way to ‘wealth’

But those with variable mortgages, which move with the Bank of Canada rate, could see an immediate (though still modest) effect. According to a survey conducted by Mortgage Professionals Canada last year, about 25 per cent of buyers chose a variable or adjustable rate mortgage. New buyers, regardless of which option they choose, can expect to pay slightly more on a monthly basis for a mortgage than in the past, which means…

The housing market could cool

Falling rates have been an important driver of the residential real estate market, since buyers can take on bigger mortgages. Higher carrying costs reverse that trend. According to Donald, the markets that could be most affected are not necessarily Toronto or Vancouver, which are popular cities for foreign buyers and speculators who aren’t as fazed by interest rates. Poloz said earlier this year that even a five per cent rate hike wouldn’t dissuade speculators.

READ MORE: The Bank of Canada’s muddled message on house prices

Instead, first-time buyers play a much bigger role in the rest of Canada, and they’re more sensitive to interest rates. Markets in these regions are already flat or cooling as the federal government and regulators have tightened mortgage rules numerous times over the past few years. Compare just about any other city to Toronto and Vancouver, for example. The Office of the Superintendent of Financial Institutions proposed even more tightening last week, creating another headwind.

But the Greater Toronto Area isn’t totally immune. Real estate activity slowed dramatically after the provincial government introduced a foreign buyer tax and other measures in April to balance the market. Sales plunged 37.3 per cent in June, while new listings rose by 16 per cent. The question now is whether Toronto will bounce back like Vancouver did just a few months after the imposition of a non-resident buyer tax.

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Caranci at TD is wagering it won’t. The Vancouver market benefited from falling rates, while Ontario’s policy changes coincide with rate hikes. “We have flat sales all the way out until next year,” she says. “We do think the combination of policy changes and a change in the mortgage rate environment will prevent that rebound.”

The loonie will rise

The Canadian dollar has already ticked up compared to the greenback in anticipation of a rate hike, increasing roughly six per cent since May to 77.6 cents U.S. While some anticipate the loonie could pull back if currency speculators want to lock in profits, the longer term trend points to a slightly higher dollar. Economists anticipate the loonie could hover between 77 and 80 cents. Generally, a higher dollar can harm Canadian companies that export goods abroad—and the export sector is only now starting to show signs of life. But even with the loonie at 80 cents, demand for Canadian goods shouldn’t be hit hard, Caranci says. “That’s still a significant discount.”