Interest Rates: Is Canada’s Mortgage Debt a Ticking Time Bomb?

If Canada’s rising interest rates lead to a wave of defaults, banks like the Toronto-Dominion Bank could be in trouble.

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Recently, the Globe and Mail ran a story claiming that Canada’s mortgage debt is a “ticking time bomb.” Citing a Desjardin economist, the story claimed that the pain for the housing market had barely started. Canada’s homeowners were put through a trial last year, as the prices of their homes went down as interest rates went up. More recently, house prices went up, but the jump was relatively small. If the Bank of Canada chooses to resume interest rate hikes at its next meeting, then the housing market might start falling again.

Indeed, the Bank may have to do so. Despite raising rates at an aggressive pace last year, the Bank is dealing with persistently high inflation. In April, the inflation rate increased, jumping to 4.4% from 4.3%. It was an unexpected jump, and it got investors worried. In this article, I will explore the phenomenon of rising interest rates and how they could affect Canadian homeowners.

Economists agree that mortgage debt is an issue

Broadly, economists agree that mortgage debt is a problem for Canada. The Bank of Canada itself holds this opinion, as do many academic economists, including those working at the commercial banks. The reason mortgage debt is a problem is because it’s so high compared to Canadians’ incomes. If your loan-to-income ratio is high, you’re more likely to default, especially if interest rates rise. So, Canadians’ debt is an issue for them.

Is this a clear and present danger?

We can gauge the risk in Canada’s housing market today by comparing the current market to one where mortgage debt did, in fact, cause problems:

In the U.S. in 2008.

That year, countless Americans defaulted on “sub-prime” mortgages. Sub-prime mortgages are high-interest mortgages issued to people who aren’t creditworthy. They help people who aren’t normally able to get loans buy houses, but they’re also extremely risky for the people who own them. In 2008, there were a lot of sub-prime mortgages floating around the U.S. market, and Americans had a high level of mortgage debt compared to average income. The situation in Canada right now is a little different. The level of mortgage debt to income is even higher than in the Great Financial Crisis, but on the other hand, the borrowers are creditworthy. It’s a mixed picture, one investors would be wise to take a long hard look at.

One area of concern for stock market investors

The risk of defaults in Canada’s housing market isn’t just an issue for real estate investors, it’s also a risk for stock market investors. Canada’s banks make a lot of money issuing mortgages to Canadians; the worse the housing market does, the more troublesome those loans become.

If you’re looking for Canadian banks to buy now, you might want to consider a U.S.-oriented one like the Toronto-Dominion Bank (TSX:TD). TD is one of the most “American” of Canadian banks, and house prices in the U.S. are much more modest than in Canada. Currently, the average Canadian house costs about 1.5 times the average American house! If you’re buying Canadian bank stocks, you will want to look at ones like TD that are geographically diversified, because mortgages are such an issue right now. That’s not to say that U.S. banks are safe: they’re even riskier, because they are not very well regulated by the U.S. government. But Canadian banks that own U.S. assets are probably safer than fully domestic Canadian banks.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button has positions in Toronto-Dominion Bank. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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