Newspaper editorials have been overflowing lately with speculation on how rising rates may lead to a surge in mortgage defaults. In response to this issue, CIBC Economist Benjamin Tal released a report that took a closer look at the facts and determined history doesn’t support this premise. Below is a summary of Tal’s report.

House Prices – Some Overshooting
Over the past two years, the degree of volatility observed in the Canadian housing market has been unprecedented. Within this short timeframe, house prices fell by almost 13%, only to rebound by an impressive 21%.

Meanwhile, resale activity is now rising by close to 67% on a year-over-year basis after falling by close to 40% in 2008. Housing starts are presently 33% higher than in April 2009 despite dropping by more than 50% earlier in the recession.

In fact, no other segment of the economy has rebounded as fast as the housing market, making it one of the real surprises of this recession. This rapid uptick in housing activity, in the face of recessionary conditions elsewhere in the economy, raises concerns about its sustainability, and is causing some to wonder whether house prices are, in fact, rising too quickly given current economic fundamentals.

Tal estimates that the Canadian housing market as a whole is indeed beginning to overshoot its “fair value”. At just under $350,000, the current average price of a home is estimated to be roughly 7% over what would be consistent with current housing market fundamentals such as interest rates, income growth, rents and demographics.

But this modest overshooting is far from uniform across the country. Those figures are skewed to western Canada, which has seen the most dramatic swings in house prices over the past 24 months. That market now appears to be overvalued by roughly 10-15%, suggesting that the imbalance in the rest of the country is much more modest.

Note, however, that overvaluation does not necessarily mean a bubble or a dramatic price correction. Given that the current overvaluation is occurring in a context of historically low interest rates, what we are most likely witnessing is a temporary period of exuberance that is “borrowing” activity from the future, as households take advantage of lower rates and accelerate their borrowing and home purchasing activities.

To the extent that current activity is simply a redistribution of sales from the future to the present, the housing market of tomorrow may be in store for a more muted level of activity. Housing starts will also catch up with the sudden spurt in demand, with the increase in supply helping to moderate price trends. Rather than plunging, house prices are more likely to stagnate in coming years (or fall modestly in the most overheated markets) as fundamentals catch up with a market that has gotten ahead of itself.

What Worries the Bank of Canada?
Rather than house prices, it is the accelerated pace of borrowing at very low rates that is beginning to raise some concerns at the Bank of Canada. For the first time in the post-war era, real household credit continued to expand through a recession. In fact, mortgage credit is now rising at a year-over-year rate of more than 7%.

This strong performance is a clear reflection of an extremely effective monetary policy in Canada. With Canadian consumer confidence only 10 points below its pre-recession level (versus a 50% decline in the US), Canada is benefiting not only from properly functioning credit channels, but also from a household sector that is willing and able to take on new credit.

Remember that low rates only work as an economic stimulus if Canadians take advantage of them. The wave of borrowing does, however, have consequences in terms of consumer debt levels. The household debt-to-income ratio is now at a new all-time high of more than 140%.

Despite a record low 4.4% effective mortgage rate, overall mortgage interest payments as a share of after-tax income are now at levels that in the past were consistent with a 6% effective mortgage rate. Since rates will no doubt at some point return to those higher levels, the Bank of Canada is worried that Canadians are making themselves increasingly more vulnerable in terms of their ability to continue to service these new, higher debt loads.

How Big is the Problem?
The relevant question, however, is just how serious a problem it is becoming, and here we have to dig a bit deeper to get the answers. Aside from an unlikely scenario of a 1970s-type stagflation, any future increase in interest rates will be in response to an improving economy. As such, any analysis of the potential impact of higher rates on the household sector in general, and the housing market in particular, should be done with tomorrow’s healthier economy in mind.

After all, the reality is that, in the past, interest rates have played only a minor role in driving mortgage default rates. Historically, it’s clear that mortgage arrear rates are highly correlated with the unemployment rate, with little or no correlation with changes in interest rates. The same goes for the economy in general. Over the past three decades, personal bankruptcies have risen twice as fast in an environment of falling interest rates than in an environment of rising rates.

And the logic here is obvious – interest rates rise when the economy recovers, and the benefits to employment and incomes of an improving economy easily offset the sting of higher interest rates on debt service costs.

Click here to read the full Benjamin Tal report.

As always, if you have any questions or concerns about mortgage affordability, I’m here to help!

With the rush of the holiday season and New Year’s celebrations now over, many Canadians are turning their attentions to their taxes. Following are some useful tips to help simplify your 2009 tax filing process and get the most out of future returns.

While the 2009 tax filing deadline is months away, January is often the best time of year for
Canadians to evaluate their overall tax strategies, especially as time will run out to realize a variety of tax-saving opportunities early this year.

Advice for homeowners and prospective homebuyers
In 2009, significant tax changes were introduced in the federal budget to benefit homeowners, prospective homeowners and even homeowners who renovated their home, cottage or condo. These include: changes made to the RRSP Home Buyers’ Plan; eligibility for the new non-refundable First-Time Home Buyer’s Tax Credit; and the Home Renovation Tax Credit (HRTC).

A $5,000 increase to the RRSP Home Buyers’ Plan means that first-time homebuyers can now withdraw up to $25,000 from their RRSPs for a down payment – tax- and interest-free.

The First-Time Home Buyer’s Tax Credit includes a $750 tax credit for first-time homebuyers to help with closing costs, such as legal fees, disbursements and land transfer taxes.

And if you’ve been thinking about doing some home renovations, keep in mind that the 15% HRTC of up to $1,350 only applies to eligible home renovation expenses undertaken before February 1st, 2010.

RRSP Contributions
A Registered Retirement Savings Plan (RRSP) continues to be one of the best tax shelters available to the average taxpayer.

Eligible RRSP contributions are deducted directly from income reported on your tax return.

This means that you save taxes at your marginal rate, which may be up to 50%, depending on your income level and province of residence. In addition to the initial tax savings when the contributions are deducted, all income earned inside the RRSP accumulates tax-free until the money is withdrawn.

Remember that you have 60 days after the calendar year to make a contribution that qualifies for a tax deduction for that year.

RESP Contributions
Registered Education Savings Plans (RRSPs) allow people to save for the post-secondary education of children or grandchildren on a tax sheltered basis while reducing taxable income. There are, of course, other advantages to RESPs. With an RESP contribution of $2,500 per child, the federal government will contribute $500 in the form of the Canada Education Savings Grant to the RESP. If a client has prior non-contributory years, the annual grant can be as much as $1,000 in respect of a $5,000 contribution.

Do You Have a TFSA?
With the introduction of Tax-Free Savings Accounts (TFSAs) on January 1st, 2009, 26 million Canadians aged 18 and older received $5,000 in tax-free contribution room from the federal government. On January 1st, 2010, an additional $5,000 in tax-free contribution room was added to each account. Now is an excellent time to discuss your options for making the most of this new contribution room.

Remember that it’s important to review your overall tax-planning strategy with a professional to ensure you’re making the most of any opportunities available to you, especially as a result of new savings and investment vehicles, credits and policy changes that came into effect for the first time in 2009.

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