Rising rates and falling prices – How it affects affordability

The Canadian Real Estate market has been interesting over the last few years, to say the least. Going back to 2020, we saw a massive influx of buyers entering the real estate market. The interest rates were at a record low, and the real estate market was red-hot, as buyers often bid the price of homes beyond what they were listed for.

Fast forward a few years, and the landscape has changed. The question is, how have the changing market conditions affected affordability? Well, there are two primary things which have changed now. Firstly, the interest rates have seen a drastic increase, and secondly, the price of homes has cooled off substantially.

These two factors usually act as opposing forces to one another. If the prices of homes are low, people rush to buy in the hopes that house prices will appreciate, and their house will be worth substantially more in the future. If, however, the interest rates are high, this tends to scare off buyers because the higher interest rates mean a higher monthly mortgage payment, and hence the costs associated with home ownership increase.

What does this all translate to in the current market? According to a recent Bank of Canada study, the higher interest rates effectively wipe out any decrease in home prices from an affordability standpoint.

The central bank’s Affordability Index ratio measures the share of disposable income a household puts towards housing-related expenses. This number increased by 48.2% in the second quarter of 2022. The increasing interest rates have come in the wake of rising inflation, with central banks fighting hard to bring inflation back to what they deem “acceptable levels.” The Bank of Canada has increased its overnight lending rate five times since March 2022. This brought it from a low of 0.25% to 3.25%. These interest rate hikes are the fastest since the mid-’90s and have effectively brought the prime lending rate to 5.45%.

Many home buyers taking out a mortgage now pay around 7% interest on their home purchases. Many people are watching the central bank of Canada closely, as interest rates play a vital role in the real estate market. If the interest rates stabilize or come down while home prices continue to soften, affordability should improve. On the other hand, if rates continue to rise, affordability will likely diminish, even if we see a stabilization or further cooling off in property prices.