Focus

July 26, 2024 | 13:44

Valid Fears of Mortgage Arrears?

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Michael Gregory , CFA

Deputy Chief Economist and Managing Director
Economics

Michael is part of the team responsible for forecasting and analyzing the North American economy and financial m... (Read more)

Scott Anderson , Ph.D.

Chief U.S. Economist and Managing Director
Economics

Scott Anderson is BMO’s Chief U.S. Economist and Managing Director. He analyzes and forecasts U.S. national and ... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal nearly two decades. He is re-sponsible for the Canadian macro-econom... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

Jennifer has been wi... (Read more)

Priscilla Thiagamoorthy

Senior Economist and Vice President
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Michael Gregory , CFA

Deputy Chief Economist and Managing Director
Economics

Michael is part of the team responsible for forecasting and analyzing the North American economy and financial m... (Read more)

Scott Anderson , Ph.D.

Chief U.S. Economist and Managing Director
Economics

Scott Anderson is BMO’s Chief U.S. Economist and Managing Director. He analyzes and forecasts U.S. national and ... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal nearly two decades. He is re-sponsible for the Canadian macro-econom... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

Jennifer has been wi... (Read more)

Priscilla Thiagamoorthy

Senior Economist and Vice President
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Feature

Valid Fears of Mortgage Arrears?

Canadian mortgage arrears will likely rise moderately further, but stay within normal bounds as interest rates decline and the economy recovers

The Bank of Canada cut rates again in July and signaled more to come, providing welcome relief to borrowers. For the first time since the financial crisis, home loan defaults in Canada are mounting and look to move higher on rising joblessness, resetting mortgages, and soft home prices. But how much higher?

In April, 0.18% of home loan payments to banks were overdue by three or more months, up modestly from recent record lows (Chart 1). However, the arrears rate is still lower than in 2019 and the current U.S. rate (1.0%), about half the four-decade average, and miles below 1983’s apex when both mortgage and unemployment rates were in double digits. For the 36% of households with a mortgage, the vast majority continue to make payments, though many have had to cut spending and tap savings to do so. Banks have also extended amortization periods to help keep payments down. This has helped stabilize aggregate mortgage service costs as a share of income, albeit near record highs.

Not all places are seeing an upturn in arrears (Chart 2). Provinces with inexpensive housing—the Prairies and Atlantic Canada—have seen steady or even falling delinquency rates, presumably because owners are carrying smaller, more manageable mortgages than in pricier regions. The upturn is mostly in Ontario and British Columbia, the two least affordable provinces, and to a lesser extent in Quebec, though default rates in all three remain below the national average.

While the current arrears rate isn’t worrisome, it likely hasn’t peaked. The unemployment rate has risen by 1.6 percentage points since 2022 and could approach 7% later this year, more than a percentage point higher than pre-pandemic norms (Chart 3). House prices have fallen 14% nationally since 2022, and could remain soft for a while in B.C. and Ontario. Mortgage rates are unlikely to return to the lows prevailing after the financial crisis. The median payment on a maturing loan could rise 34% by the end of 2027, according to the Bank of Canada (December 2023). For some borrowers, payments will modestly exceed stress-tested levels. Others, however, will benefit from fixed rates that are now less than the qualifying rate, which for many was 5.25%.

Though rising, there’s reason to believe the arrears rate won’t breach long-run norms. More job seekers, rather than big layoffs, explain the spike in the jobless rate. The number of persons receiving employment insurance benefits remains low, meaning most families haven’t suffered a loss of income. An expected firmer economy and slower population growth (due to curbs on temporary immigration) should pull the jobless rate down next year and lift real wages, while home prices could improve on lower interest rates.

To capture the combined effect on the arrears rate of four key drivers—the jobless rate, real mortgage rates, real wage growth and home price growth—we estimated a regression equation. Each driver enters the equation significantly and with the correct sign, with lags ranging from two to five quarters. The equation explains about four-fifths of the quarterly variation in the arrears rate, while the standard error (0.06%) is half the standard deviation of the historical series (not bad).

Chart 4 shows the equation’s estimate of the arrears rate over the past three decades, as well as the three-year ahead outlook based on our expected path for the explanatory variables (a moderate pickup in real wages and home prices, and a 75-bps decline in five-year mortgage rates that is mostly neutralized by a similar decline in inflation). Three results stand out. First, the 2020 spike in the jobless rate should have lifted the arrears rate above long-run norms (Chart 5). Instead, the actual rate declined due to income-support programs, aggressive rate cuts, and the economy’s rapid recovery. Second, the estimated rate of 0.23% last quarter is significantly higher than the actual rate in April, with the former lifted by a rising jobless rate and the latter held down by the lack of layoffs. Third, the equation predicts the arrears rate will peak at 0.34% by mid-2025, just shy of the historical norm, before settling around 0.28% in the medium term.

What if things don’t go as expected? If the jobless rate rose three percentage points to above 9% due to a weaker economy, the arrears rate would modestly surpass its long-run mean, all else equal. A likely decline in home prices and real wages would pile on, partly offset by lower interest rates. If home prices tumbled another 14%, all else equal, the arrears rate would peak just below the long-run mean.

Bottom Line: Canadian mortgage arrears will likely rise moderately further, but stay within normal bounds as lower interest rates support a modest recovery in the economy and house prices, and limit the strain of mortgage resets. The mortgage stress test, introduced in 2016, should pass its first big test.