Bank of Canada Governor Tiff Macklem said recent gains in home prices aren’t sustainable and warned households against taking on too much mortgage debt because interest rates will eventually rise.

In an opening statement at a press conference to discuss financial stability, Macklem said some households have taken on “significantly” more debt, with many carrying very large mortgages relative to income. Borrowers and lenders need to understand that interest rates won’t always be at historic lows, and home buyers won’t be able to rely on rising values.

“It is important to understand that the recent rapid increases in home prices are not normal,” Macklem said, after the release of the Bank of Canada’s annual Financial System Review. “Counting on ever higher house prices to build home equity that can be used to refinance mortgages in the future is a bad idea.”

The comments come on the heels of one of the biggest upswings in Canadian housing ever, with prices climbing more than 30 per cent over the past year in many markets. Canadians are so alarmed by the red-hot housing market that many say they’d like to see the central bank raise the cost of borrowing to dampen demand for real estate and stabilize prices.

In its report, the Ottawa-based central bank said debt vulnerabilities are intensifying amid a surge in housing prices that’s being driven in part by speculative activity. There are signs people are buying houses with the expectation prices will continue to rise, which creates unsustainable dynamics. Taking on larger mortgages, meanwhile, puts households in a precarious situation should the economy take a downward turn.

Separately on Thursday, Canada’s banking regulator formalized a proposal to make it more difficult for home buyers to secure financing. Under the new qualification rules, which go into effect June 1, buyers will have to show they can afford a minimum rate of 5.25 per cent.

Laundry List

“Interest rates are unusually low,” Macklem said. “Borrowers and lenders both have roles in ensuring that households can still afford to service their debt at higher rates.”

How this analysis plays into the central bank’s policy is unclear. Growing household vulnerabilities could give policy makers more reason to consider raising borrowing costs, for example, though higher rates would also inflate risks -- such as slow growth or a housing price correction. Macklem’s next interest-rate decision is due June 9.

Thursday’s report did find Canada’s lenders could absorb a significant amount of losses in the case of another shock. The central bank said household debt and housing market vulnerabilities probably don’t pose a significant systemic threat to bank solvency, even though they could undermine future growth.

“The Canadian financial system went into this crisis in a solid position and has proved to be resilient,” Macklem said in a statement. “This reflects sound risk management across a range of financial system participants combined with Canada’s strong regulatory and supervisory framework.”

The financial system review outlines the central bank’s thinking on risks and can seem like a laundry list of concerns. Other vulnerabilities cited in this year’s report include liquidity worries in bond markets in times of stress, mispricing climate risks that can leave investors exposed to sudden losses due to the transition to a low-carbon economy, and the viability of businesses once government supports end. The rapid evolution of cryptocurrency markets was also listed as a vulnerability, as it has been in the past.

The two first vulnerabilities cited, however, were household debt and Canada’s red-hot housing market. The quality of new mortgage borrowing deteriorated during the pandemic, the central bank said, citing data showing the share of new mortgages with a loan-to-income ratio above 450 per cent rose substantially in the second half of last year to 22 per cent of all mortgages. That’s above the range seen in 2016 and 2017, the report said, when regulators tightened mortgage qualification rules.

The vulnerability associated with household indebtedness “is significant and has increased over the past year,” the report said. “These highly indebted households have less flexibility to deal with sudden financial changes, such as a job loss or a drop in the price of their home.”

‘Extrapolative Expectations’

The Bank of Canada did say that household finances on the whole haven’t deteriorated thanks to government support programs, but mortgage debt is growing and some households may be overleveraging.

The central bank also said imbalances in the housing market are increasing, even though it believes the strong gains in prices largely reflect fundamental factors. The central bank found there are signs of more speculative activity in some key markets that could post financial stability concerns.

The Bank of Canada published a new house-price exuberance indicator that found Toronto, Hamilton and Montreal are experiencing episodes of “extrapolative expectations,” with Ottawa nearing that threshold. This means that more Canadians are buying homes with the expectations prices will continue to rise and so they are more willing to bid above the asking price.

Like the U.S. Federal Reserve and European Central Bank did this month in their own financial stability reports, the Canadian central bank also highlighted concerns associated with any repricing globally of risky assets with stretched valuations.