How Interest Rates Impact Home Prices and Your Budget

By John Peloza, CFA | 7 minute read

On June 1, 2022, the Bank of Canada increased its prime interest rate from 3.2% to 3.7%. The 50 basis point increase marks the third rate hike in three months, with prior increases of 25 and 50 basis points in March and April. In total, the 1.25% hike in the prime rate is the first movement since March 2020, when the Bank of Canada slashed its prime rate from 3.95% to 2.45% as a response to the widespread business interruptions caused by the COVID-19 pandemic. With inflation in 2021 rising at its fastest pace in over 30 years — and with the prime rate before March 2022 at its lowest level since 2010 — the recent increases aim to normalize interest rates to address rising prices, particularly home prices, which have increased by 50% over the past two years.

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As the prime rate rises, so do the mortgage rates that Canadian banks and lenders offer to homebuyers in need of additional financing. During the June 1 announcement, the Bank of Canada stated it will continue raising rates as long as high inflation persists. The recent increases are leaving many homebuyers unsure of what they can afford. During April and May, the Toronto Real Estate Board reported a 40% decrease in homes sold compared to the same period in 2021, with many homebuyers sitting on the sidelines to see what happens next.

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Variable vs. fixed mortgage rates

While a standard mortgage is paid off over 20 to 30 years, the mortgage terms are typically renewed every four to five years. For the holder of a fixed-rate mortgage, the monthly payments won’t change until the mortgage is renewed at the end of the term, and will be based on the latest prime rate. This provides peace of mind throughout the mortgage term as a locked-in monthly mortgage payment provides certainty about payment amounts, simplifying the household budgeting process. With a variable-rate mortgage, any interest rate change will immediately alter the monthly mortgage payment, either for better (a decline in the prime rate) or worse (an increase in the prime rate).

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For this reason, variable-rate mortgages usually offer a lower interest rate than their fixed-rate counterparts. The lower rate reflects the increased risk a buyer is assuming throughout the variable mortgage term, since rates may rise at any time and place immediate pressure on the buyer’s monthly budget. With interest rates expected to continue to rise, there is a significant difference between fixed and variable mortgage rates offered by the major Canadian banks. For example, following the June 1 rate hike, RBC’s five-year fixed mortgage offers a 4.59% interest rate, compared to its five-year variable mortgage at 3.3%. While the variable-rate mortgage provides substantial monthly savings at the start, future rate increases may lead to monthly payments exceeding the fixed mortgage option during the five-year term.

The decision to buy a fixed-rate versus variable-rate mortgage will depend on a homebuyer’s risk tolerance and their assessment of where interest rates will go during their mortgage term.

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Purchasing power

Beyond an initial down payment, most homebuyers will need a mortgage to help finance their home purchase. But first, a buyer needs to apply for a mortgage. Based on a buyer’s income level, personal savings, credit score, and external factors such as the Bank of Canada prime rate and mortgage stress test, a lender will provide a maximum amount of financing. Keep in mind that the amount a homebuyer is approved for will vary based on the type of mortgage and length of the mortgage term. Higher interest rates will reduce the maximum amount a buyer can borrow, subsequently reducing the maximum amount they can bid on a property.

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The majority of homebuyers will require a mortgage at some point in their lives (almost 9 in 10 Canadian homeowners aged 25 to 44 have one). Rising interest rates result in more expensive homes being affordable to a smaller group of qualified buyers. This has the potential to reduce competition and calm rapidly rising home prices. However, given Canada’s

 housing supply challenges, many homebuyers will need to reconsider where they plan to live to be able to afford a home.

Interest rates remain comparatively low

Despite short-term fluctuations, the Bank of Canada prime rate has been steadily declining since 1981, when it peaked at a shocking 22.75%. Four years later, it had fallen to 10.25%, highlighting the risks and rewards of a variable-rate mortgage.

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As the prime rate has fallen over the years, increased purchasing budgets for buyers have caused home prices to increase across the country. Back in 1981, the average price of a Canadian home was $76,000; now it’s $746,000. While some of this tenfold increase can be explained by growth in average household income, remember that even if your income stayed flat, declining mortgage rates would have made an expensive home more affordable.

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Over the past 20 years, the prime rate has averaged 4.56%, compared to its current rate of 3.7%. As Canadians across the country are feeling the pinch at the grocery store, gas station, and finding a suitable place to live, the expectation is that further increases will be implemented to bring the prime rate back in line with historical levels.

One part of the story

Real estate prices are driven by the supply-demand balance: how many homes are available for sale compared to how many qualified buyers are looking for housing. While interest rates impact what a buyer can afford, they only tell part of the demand story. Demographic trends, such as increased immigration to Canada and a large cohort of young, first-time homebuyers, will continue to place pressure on the low housing supply across the country. Furthermore, no two markets are the same. The accelerated trend of remote work, driven by the COVID-19 pandemic, has made some cheaper secondary markets more attractive, especially as buyers are priced out of more expensive cities due to recent interest rate increases. While no one can be sure of what the future holds, doing your research on interest rates and mortgage types will ensure you make the most of the homebuying experience.  

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