How to Afford a House When Housing Becomes Less Affordable

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“Looking ahead to 2014 and 2015, we anticipate a further – albeit gradual – deterioration in affordability,” reads a recent TD Economics special report. You might be excused for spewing your coffee upon reading that. In Vancouver, payments on an average mortgage already take up a mind-boggling 60% of an average family’s income, according to said report. How can buying a home or holding a mortgage be getting less affordable?

Luckily, the future isn’t as dire as you might think. Economists measure affordability based on three variables: incomes, home prices and interest rates. If you look at the first two, housing in Canada appears eminently unaffordable: Over the past 15 years, home prices have climbed at a 6% clip per year on average, compared to 1.5% for incomes. Enter interest rates, though, and the picture changes. Back in April, you could get a 5-year fixed mortgage rate for as low as 2.64% – almost five percentage points below the 7.5% that’s considered a “normal” rate. That might be little consolation to Vancouverites facing the city’s exorbitant prices but, in Canada as a whole, record-low borrowing costs have kept affordability around historic levels.

What’s going to make it a bit more costly in the next few years for Canadians to buy a house or refinance their mortgage is primarily interest rates. Price-growth, the bank predicts, will be flat or inch forward at a slow pace along with incomes. Interest rates, though, are poised to climb. The trend, of course, has already started: 5-year fixed mortgages are 0.7% higher than they were before the summer. But TD predicts 5-year bond yields, which influence longer-term mortgages like 5- and 10-year fixed terms, could add another 0.7% by the end of 2015, while the Bank of Canada might raise its key interest rate, which drives variable and 1-4 year fixed term rates, a full percentage point by then. Picture 4.05% for a fixed mortgage and 3.45% for a 5-year variable rate, two years from now. By 2018, fixed mortgage rates might hover around 5.6%, TD economist Diana Petramala, who co-authored the report, told MoneySense.

Though the general trend is up, you might have noticed the roughly 1% gap between fixed and variable rates. Lots of other Canadians certainly have. “Our Vancouver office has noticed more people asking questions about variable rates, and more than 50% of our clients are now choosing them over the fixed,” Chris Rempel, a broker at True North Mortgage.

The good news about Canada’s housing market heading back to normal is that “back to normal” doesn’t only mean higher interest rates — it also means a sizeable difference between fixed and variable rates, making the latter comparatively more attractive than they have been in some time.

And the spread is likely to widen, for a couple of reasons. On the one hand, with the global economy picking up, slow-growing Canada is no longer such a hot asset, which is taming investors’ appetite for Canada bonds. Expect bond prices to be on a downward trend, and yields, which move in the opposite direction, on an upward one. This is compounded by the impending roll-up of the Federal Reserve’s so-called quantitative easing policy. This will push up U.S. long-term interest rates, which, in turn, influence Canada’s. But sluggish domestic growth is also the reason why the Bank of Canada, which controls short-term interest rates, dropped its promise to raise short-term interest rates back in October and will likely stay put until late next year.

This isn’t to say you should choose your mortgage based primarily on economy forecast — in fact, you absolutely shouldn’t. Even a variable rate enthusiast such as Schulich School of Business Professor Moshe Milevsky is on record encouraging highly leveraged buyers to go for a fixed rate mortgage no matter what. But if you have a stable job, a small mortgage relative to the value of the house and little fixed costs and debt, you might want to give those variable rates some serious consideration.

Even with affordability declining, it seems, there are silver-linings for smart homebuyers.