While real estate is often focused on numbers and statistics, we can’t forget that it is about people, and people often frame their realities using stories. As such, we wanted to talk about the story for homeowners in the last little while and what the next chapter will look like given all the recent changes. Grab a mug of hot chocolate and settle in for the story.
Once upon a time, someone bought a home.
This story should be familiar to you, either because something very similar happened to you, or to people you know.
The story starts with someone buying a home. They save up a down payment, they work with a trusted Realtor to find, negotiate and close on the home and the happy day arrives when they are given the keys and settle into their new home.
Over a period of time, they live their lives in the new home, all the while, making their mortgage payments and not really paying a lot of attention to what’s going on in the real estate market. While it can be all-consuming when you’re looking to buy a place, once you own your new home, your interest in the latest listings and forecasts naturally wanes.
Eventually the day arrives when they discover that the home no longer suits their needs. Maybe they’ve had a life change with the arrival (or loss) of family members, perhaps they need more (or less) space, or their work situation could have changed and with it, where they want or need to live.
As they begin to assess options, a very important question is raised – how much can they spend on their next home? While income, credit scores, interest rates and other aspects will impact how much of a mortgage they can be approved for now, we’re often involved to help determine the value of their current home.
For the last 20 odd years (depending on which dataset you look at), the story for home owners has been a positive one, with price appreciation. In addition, for the last 12 years or so, mortgage rates have been at or near historic lows, which means homeowners paid less interest and paid down more principal.
Combine the two and if you or someone you know has bought and financed a home in the GTA in the past dozen years, this is what happened.
- The value of your home has increased considerably as the real estate market went up.
- The equity in your home increased as well due to your mortgage payments including significant principal repayments.
When the time came to consider a new home, you found that not only was your home worth a lot more than what you paid for it years ago, you also had a much smaller mortgage than when you bought it. Hurray!
The combination of these two factors led to home owners being able to move up the property ladder. While not all homeowners saw the exact same levels of appreciation, or had qualified for the lowest possible interest rates, in general, the story was a very positive one.
Even if a homeowner hadn’t increased their income substantially during the time in the home, they had a significant amount of capital available to allow them to move up the property ladder. In many cases, these moves took place with the homeowner not seeing a significant difference in their monthly mortgage costs, despite buying a home that was hundreds of thousands dollars more expensive than their prior home.
It’s a good story, with happy homeowners, moving up and forward, finding new and better homes that they can afford, primarily because they were smart enough (or lucky enough depending on who you ask) to buy a home and finance it at a low rate.
Nothing stays the same forever though, and we’ve seen some significant changes in the real estate markets in the GTA in 2022, which leads us to an important question.
What will the next chapter look like? Odds are, it won’t be as good.
When we look at what has changed this year, we see that the two factors that made being a homeowner such a good story have changed. We’re going to have to go into a few numbers but I promise we’ll get back to the actual story bit soon.
First off, let’s look at interest rates.
The Bank of Canada has had eight policy interest rate announcements in 2022, as is the norm for the institution. These overnight rate announcements have a direct impact on the variable rate for mortgages as these rates are what the banks use to set their prime rate.
When we look at what the results of the eight rate announcements were this year, we see that were seven rate hikes. The latest and last for the year (which took place on December 7, 2022), saw the Bank of Canada raise its overnight rate by 50 basis points to 4.25 per cent. The last time the bank’s policy rate was this high was in January 2008.
We won’t focus on the numbers too much, but it’s worth pointing out that at the start of the year, you could get a 5-year variable rate in Canada for 0.85%. After the latest BOC announcement, the best out there for a 5-year variable rate in Canada is 5.30%. That’s an increase of over 500% since the start of the year. Ouch.
The impact of these changed interest rates on how much of your monthly payment is principal versus interest is massive.
At the start of the year, if you were lucky enough to get the lowest possible variable interest rate mortgage, 81% of your mortgage payment would have been principal repayment. That’s from your first payment and it just gets better over the term. On average, you’d have paid 83% principal and 17% interest.
With the latest rates, your first payment would see you pay 27% principal repayment and 73% interest. Not quite a total reversal, but pretty close. Over the course of the term, it gets a bit better, and when you look at all of your payments, you’d pay 31% principal and 69% interest.
What about fixed rate mortgages?
On the fixed rate side, things aren’t much better. These fixed rate mortgages are based on bond yields and they have also gone up considerably in 2022. At the start of the year, you could get the best high-ratio, 5-year fixed rate in Canada for 2.34%. By the end of the year, the best option is 4.69%. That’s just over 100%, which in layman’s terms, means they doubled. Not nearly as bad as what happened with variable rates, but still a huge change.
The impact of these changed interest rates on how much of your monthly payment is principal versus interest is also huge on the fixed rate side.
At the start of the year, if you were lucky enough to get the lowest possible fixed interest rate mortgage, 56% of your mortgage payment would have been principal repayment. That’s from your first payment and it just gets better over the term. On average, you’d have paid 59% principal and 41% interest.
With the latest rates, your first payment would see you pay 31% principal repayment and 69% interest. Not quite a total reversal, but pretty close. Over the course of the term, it gets a bit better, and when you look at all of your payments, you’d pay 35% principal and 65% interest.
The end result is that whether you went with a fixed or variable rate mortgage with a purchase right now, only about a third of your mortgage payment is principal repayment. When homeowners who bought recently look to move up the property ladder or even just renew their mortgage, they will not be seeing the significant level of equity freed up by their mortgage payments that we’ve been enjoying over these years of incredibly low interest rates. They will have paid off some of their mortgage, but the bulk of it will still be there and need to be paid off before they have the remainder available for a new purchase.
Into the Unknown
The other part of the equation for our story moving forward is how much will home prices have appreciated when current buyers are looking to sell. While the specific appreciation varied based on the type of home, location and even price point, the real estate market has been on a tear for the past couple of decades.
When current buyers are ready to make a move, will their homes have appreciated to the extent that it is financially feasible? We already know that they won’t have built up a significant nest egg in the form of principal repayment during their mortgage term, so the pressure lies on the real estate market appreciation to allow it to happen.
If we see a mostly flat real estate market for an extended period of time, then homeowners who want or need to move up the property ladder will find themselves in a bit of a bind. Unless they have had significant career and income advancement during that time, they won’t have the ability to cash out on their current home and move up the ladder for the same cost.