Homeowners due to renew their mortgage over the coming years will face steep jumps in payments, according to the Bank of Canada, with median monthly payment increasing by more than 60 per cent for those with a variable rate mortgage.
So far, many homeowners have been able to withstand the sharp rise in interest rates with mortgage defaults remaining below 0.5 per cent across Canada.
But the central bank warned that the ability of households and businesses to service their debt has become one of the main risks to the stability of the country’s financial system.
“Higher debt-servicing costs reduce financial flexibility or households and businesses and make them more vulnerable in the event of an economic downturn,” the bank said in its annual Financial Stability Report released on Thursday.
Since the central bank started aggressively hiking interest rates in March 2022, about half of the country’s outstanding mortgages have renewed at higher rates. Currently, the bank said stress among mortgage holders is unchanged and income growth, accumulated savings and a reduction in spending has helped homeowners handle the higher interest rates.
But that could change if unemployment rises and homeowners lose jobs. Over all, the report showed how renters are facing greater financial stress and have been increasingly relying on their credit and have been missing payments on their car loans and credit cards.
In many ways, the report had a more optimistic tone than the one published last year. At that time, financial markets were fragile following the collapse of Silicon Valley Bank in the U.S., the emergency takeover of Swiss bank Credit Suisse and the near meltdown of British pension funds.
That said, the central bank is becoming more concerned about certain corners of the financial system. Canadian hedge funds and pension funds have added considerable amounts of leverage over the past year, making them vulnerable to a sudden shift in bond prices. And the prices of riskier assets like stocks and corporate bonds look overstretched and susceptible to a correction, especially if there’s a change in market expectations about the path of interest rates.
The report said the office real estate market is under pressure with office vacancies rising in major cities. That includes Toronto, the country’s financial capital, where the vacancy rate is nearing 20 per cent.
The report said that small to medium-sized banks had the highest exposure to the commercial real estate sector with loans to real estate developers and commercial mortgages accounting for 20 per cent of their loan book. For large banks, commercial loans make up 10 per cent of their portfolio.
The central bank policy rate has been at 5 per cent, a two-decade high, since last July. Many economists and traders expect the bank to begin cutting rates this summer, though interest rates are not expected to drop to levels seen during or before the pandemic.
That means homeowners who are up for a mortgage renewal will still face a large increase in monthly payments. Those that will shoulder the largest gain are homeowners with a variable rate mortgage with a fixed monthly payment or where the monthly payment has remained the same throughout the term of the mortgage.
For those mortgage holders, the steepest rise will occur in 2026 with a median percentage increase of more than 60 per cent, according to bank estimates. In 2025, the median increase in the monthly mortgage payment is more than 50 per cent and this year, about 30 per cent.
For those with a fixed-rate mortgage where the interest rate does not change over the loan term, the shock at renewal time will not be as great. The bank estimates median payments rising more than 20 per cent in 2026 and by smaller percentages in 2025 and 2024.
Over all, homeowners who took out a mortgage last year are spending a higher share of their income on loan payments compared to those who took out a mortgage prior to the start of the pandemic. More than one-third of new mortgages had a debt service ratio greater than 25 per cent at the end of last year. That is double the level in 2019.
The central bank determined that commercial banks are in fairly good shape to handle potential losses. Loan-loss provisions at Canada’s large banks are around 20 per cent higher than before the pandemic. This increase has hit profits, but added a layer of resilience in case borrowers default on their loans. The Office of the Superintendent of Financial Institutions, Canada’s banking regulator, has also forced banks to increase their capital and liquidity buffers.
The report did note, however, that Canada’s small and medium-sized banks are in a tougher spot. Some of these institutions specialize in lending to higher-risk clients and tend to issue shorter-term mortgages. The share of mortgages in arrears has risen more for these institutions.
“The difference in mortgage arrears at smaller lenders likely reflects differences in the borrower profiles and in the timing of mortgage renewals,” the report said.
A similar divide appears to exist between smaller and larger non-financial businesses. The report said that large companies are handling their debt loads fairly well and don’t pose a significant default risk.
By contrast, small business insolvencies have risen sharply over the past year. This is likely the result of both higher debt-servicing costs and an end of pandemic-era government support programs, the report said.
The report did flag one area of mounting concern within the financial system: Asset managers, such as pension funds and hedge funds, are taking on significantly more leverage to conduct certain trading strategies. Most of this borrowing is happening in repo markets, where financial institutions borrow money on a short-term basis against high-quality collateral.
Canadian asset managers have increased their repo borrowing by 30 per cent over the past year, with hedge funds up 75 per cent and pension funds up 14 per cent. This is mostly to conduct a “cash-futures basis trade,” where investors use a mix of short and long-positions to profit from price discrepancies in the bond market.
This increase in leverage exposes investors to a sudden shift in bond prices, which could occur if there’s a change in expectations about the path of interest rates. This could spark a fire sale for bonds that would reverberate through the rest of the financial system.
“The largest pension funds and insurance companies are typically sophisticated users of leverage that manage their liquidity risk and use liquidity coverage ratios to monitor planned and potential outflows,” the report noted. “Nonetheless, even sophisticated users can run into difficulties during periods of market stress, as seen in the October 2022 UK pension fund experience and during the March 2020 ‘dash for cash.’”
