Sudden increases in mortgage payments place a heavy burden on household budgets, forcing families to cut back on other goods and services. Even when mortgage rates decrease, the reduction in consumer spending persists, affecting retail, tourism, and other industries. This leads to reduced government revenue from sales taxes on consumer goods.

Mortgage rates began to climb in Canada in early 2022. The hikes first affected those with variable-rate mortgages. However, most Canadian mortgagors have fixed-rates, allowing them to avoid higher payments in the short term. Nevertheless, given that the typical mortgage term is five years, nearly all borrowers must refinance by 2027. This suggests that the peak decline in consumer spending has yet to materialize.

In a study released in June, Panagiotis Bouras and others at the Bank of Canada estimated the decline in consumer spending caused by homeowners’ higher mortgage burdens. They found that mortgage payments increased by nine per cent from early 2022 to April 2024 but have yet to peak. The study estimates that payments will be about 17 per cent higher in 2027 relative to early 2022.

The authors found that, net of mortgage payments, the average household disposable income declined by three per cent in April 2024 relative to early 2022 and will likely decline up to five per cent by 2027. This implies that, on average, Canadian households will have lower purchasing power thanks to expensive mortgages.

The decline in disposable income affects households with liquidity differently than those without it. Households without liquidity, which are asset-poor, consume all of their disposable income. In contrast, unconstrained households with assets and savings respond differently to mortgage shocks, adjusting their consumption according to their current and future income and savings scenarios.

After adjusting for household liquidity, the authors estimated that mortgage borrowers reduced consumption by 2.8 per cent by April 2024, however, as more mortgages are refinanced, the decline in spending is projected to reach 3.8 per cent by early 2028.

The most intriguing finding in the Central Bank’s study is that the decline in consumption will not readily reverse when rates are cut. This is because borrowers contribute less to their principal amount during a sustained period of higher rates, resulting in a larger balance owed to the lender and, consequently, reduced spending throughout the amortization period.

The bank’s findings are consistent with experiences in other countries. In a Danish study published earlier this year in the Review of Economics and Statistics, Henrik Yde Andersen and colleagues discovered that an average increase of nine per cent in mortgage instalments led to a three per cent drop in consumption among Danes whose interest-only mortgages were converted to interest-plus-principal with a maximum 20-year amortization period.

Denmark allows interest-only mortgages for up to 10 years. After this period, amortization begins, with a maximum term of 20 years. Interestingly, borrowers knew their monthly mortgage payments would increase once amortization commenced, yet it appears they did not plan for it. Instead, they responded by cutting consumption to manage the anticipated shock.

The Bank of Canada study assumes that policy rates will decline by approximately 200 basis points by late 2026. This is far from certain. Some experts believe the rate cuts could be slower and may “not reduce borrowing costs for many mortgages.” Hence, the decline in consumption could be steeper and have a longer duration than the Bank estimates.

Don Drummond, a fellow-in-residence at the C.D. Howe Institute, observed that because bond yields are “quite low” relative to the current policy rate or estimated future neutral rate, the “cost of longer-term mortgages might even go up.” In other words, the odds of a significant decline in mortgage rates and payments in the next few years are not set in stone.

All of this suggests that businesses and governments should prepare for a prolonged period of diminished consumption beyond the typical rate-cutting cycle and adjust their operations and strategies accordingly. Even if housing sales and prices increase in the short term, the downward trend in consumer spending could negatively impact other sectors as well.

Murtaza Haider is director of Regionomics Inc., a consultancy specializing in predictive analytics and machine learning. Stephen Moranis is a real estate industry veteran. They can be reached at the Haider-Moranis Bulletin website, www.hmbulletin.com.

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