UCalgary economist says impact of rising interest rates will vary from person to person

You may have seen headlines in your feed recently like, “Typical mortgage payment could be 30% higher in 5 years,” or “1 in 4 homeowners say rising mortgage rates could push them to sell.”

These headlines sound concerning and even scary, especially for young grads or students who may be in the market to buy their first home in the next few years. But is there a need to panic? Or are we just seeing the down end of a cycle that any economic system naturally goes through?

To help sort it all out, we’ve enlisted the help of UCalgary economics professor Dr. Trevor Tombe, PhD, to navigate the world of mortgage rates and housing prices.

Q: How would you define a mortgage rate?

A: A mortgage rate is an interest rate charged on a loan used to purchase a house. Like any loan, there is a cost. Lenders need to be compensated for providing a borrower funds, and at what per cent of interest. For mortgages, this interest is normally part of your monthly payment and therefore only a certain share of your monthly payment actually lowers the amount you owe the bank — the rest is the interest payment. 

Q: Does everyone face the same mortgage rates and are there different kinds of mortgages?

A: Not everyone faces the same mortgage rate, and there are a lot of factors that determine what an individual’s specific rate will be. There are also differences across financial institutions, and some people put in more effort searching for lower rates than others who just go to their local bank. Given the size of a mortgage for most people, it is worth comparison shopping to get the lowest rate possible.

There are two kinds of mortgages you can get. A fixed-rate mortgage involves signing a multi-year agreement to lock in a particular mortgage rate over the entire term. A variable-rate mortgage involves a mortgage rate that can rise or fall throughout the mortgage term depending on market conditions. If interest rates rise — as we are seeing now — then so, too, will your mortgage rate.

Regardless of which one you choose, there is a little bit of a gamble. You might lock in an interest rate and then in subsequent months or years interest rates in the economy might fall, and then you’re stuck with the higher rate. However, the flip side is also true: you can lock in a rate, and in a couple of months or years, like we’re seeing right now, interest rates can rise, and you benefit from that.

Q: Why do these rates tend to fluctuate as much as they do?

A: The number one factor we’re observing today is policy. Monetary policy, to be precise. Interest rates are something that central banks can directly influence. They can increase or decrease the overall supply of money, and they do that to achieve their main objective of keeping inflation low and stable.

Central banks can choose to lower rates, like during a recession or the pandemic. This is a way to support the economy during these tough times. In times where the economy is growing and inflation pressures start to appear, they increase interest rates to try and slow economic growth. That’s what we’re seeing now.

Q: How did we get to the point where we are being warned that mortgage payments could be 30 per cent higher in five years?

A: First, keep in mind that rising interest rates affects each of us differently. No one should be under the impression that their mortgage payments will necessarily rise by that much. However, we’re now seeing interest rates rise rapidly and that will mean borrowing money for any reason is going to become more costly. That will increase the costs of mortgages in the future, but like I said, sometimes individuals will have locked-in rates that they won’t see change until they renew, which may be many years from now, and who knows what interest rates will be then.

But to your question, how did we get into the situation where the rates are rising? In any economic recovery, interest rates will gradually rise. This is normal monetary policy because central banks want to ensure inflation doesn’t grow too high. The difference this time is the speed of the interest increase, and a lot of that is because, in retrospect, central banks should have started to increase interest rates earlier.

The recovery from COVID was very strong, and there may have been hesitation to move too quickly, but we’ve seen inflation increase to levels not seen since before I was born. So central banks around the world are correcting for not moving faster with normalizing monetary policy last year. Don’t get me wrong, I don’t think central banks should be blamed for not moving earlier — given the information they knew at the time, they made the best decision they could to support recovery. Things are just moving really quickly today and uncertainty is unusually high.

Q: Let’s talk hypothetically. Jane Smith is a recent UCalgary grad who just got an entry-level job in her field, but she has $20,000 in student debt. However, she wants to buy her first home — should she do it?

A: There are two competing forces here. On the one hand, you might think higher mortgage rates are going to negatively impact Jane Smith and her ability to buy her first home. On the other hand, higher interest rates across the whole economy can lower real estate prices. Indeed, we are seeing prices start to fall in some cities today.

We don’t yet know what the net effect of this will be, but there are some projections out there that say we might see home prices decline nationally by around 10 per cent over the next year. So yes, mortgage rates are climbing, but home prices are falling, and so it’s hard to say which of these two is most important for Jane Smith. After all, if the home price falls, you don’t need to borrow as much. So even if mortgage rates are higher, the monthly payment may be lower. 

Q: Can anyone get a mortgage, or is there a process to it?

A: When you go to a mortgage lender, they don’t just give you one because you asked for it. You have to apply. You provide them information about your employment situation, your income, the home price, and so on. Right now, lenders will also do a bit of a “stress test” to see whether you will still be able afford your home if interest rates rise. The standard for that test is around two per cent. You will not be approved unless you are able to pass that kind of a stress test. For most borrowers, the increase in the interest rate is affordable. Even though it’s a hit, and an unpleasant hit, to the household budget, it’s not something where it would tip someone into not being able to afford the mortgage.

Q: As an economist, would you recommend Jane Smith buy a house right now?

A: Whether buying a house makes sense to an individual is going to vary. There’s a massive misconception out there that buying is better than renting, but that is not necessarily the case. Interest costs are a pure cost to you as a homebuyer in the same way that rent is. So my advice to Jane Smith (and to anyone) is to sit down and think about that rent-or-buy decision carefully. There are lots of great online calculators that help you figure out whether buying is cheaper than renting.

We should never just assume that buying is better, or that people should feel disappointed that they’re not buying a home. Sometimes, the smarter thing to do is to rent, even if you could afford to buy a home.