(Updates with tightening of mortgage lending rules)
By Julie Gordon and David Ljunggren
OTTAWA, May 20 (Reuters) - Canada said on Thursday it would tighten rules on mortgage lending starting next month after the Bank of Canada earlier warned that the hot housing market and high household debt levels had left the economy more vulnerable to economic shocks.
The country's financial regulator and the Finance Department said separately that borrowers of both uninsured and insured mortgages must show that they can afford loans that are the higher of their current rate plus 200 basis points, or 5.25%.
That is a tweak to a mortgage stress test https://www.reuters.com/article/cbusiness-us-canada-housing-regulation-idCAKCN1C823O-OCABS Canada introduced in 2017 to ensure that borrowers are able to make payments even when interest rates increase.
It replaces the earlier benchmark that used banks' advertised rate - currently 4.79% - to determine the minimum qualifying rate.
"The recent and rapid rise in housing prices is squeezing middle class Canadians across the entire country and raises concerns about the stability of the overall market," Finance Minister Chrystia Freeland said in a statement.
Canadian home sales and prices have surged in recent months, as demand has outpaced available supply. The average price nationwide jumped 41.9% in April from the previous year, when prices inched down amid a pandemic plunge in sales.
The housing boom has led to a jump in mortgage debt, sending total household debt up sharply since mid-2020.
Both the Finance Department and the regulator initially proposed a change to the benchmark in February 2020 but dropped it as the coronavirus pandemic took hold.
A housing-market boom and linked rise in mortgage lending have helped buoy economic growth in the short term but increase the risk over the medium term, the central bank said in its annual review of financial systems, making clear it would not raise interest rates to cool the frenzy.
For the central bank, the focus remains on getting the hardest-hit segments of the economy through the COVID-19 crisis, Bank of Canada Governor Tiff Macklem said. He also said tighter mortgage rules would be helpful.
"We do factor housing into our monetary policy decisions but we do have to look at the whole economy," he told reporters. "There are important parts of the economy that remain very weak and the economy needs our support."
Macklem made his remarks when asked if guidance on rate hikes could change to deal with rising home prices. The bank has signaled it will hold its key benchmark interest rate at a record low 0.25% until the second half of 2022.
But in his strongest comments yet on housing, Macklem said that recent price surges were "not normal" and that interest rates would go up eventually.
"Some people may be thinking that the kind of price increases we've seen recently will continue. That would be a mistake," Macklem said.
"The vulnerability associated with elevated household indebtedness is significant and has increased over the past year," the bank said, adding the quality of new mortgage borrowing had deteriorated.
About 22% of all new mortgages had a loan-to-income ratio above 450%, the bank said. That is above the range seen in 2016–17, before Canada's financial regulator introduced the mortgage stress test intended to cut out risky lending. (Reporting by Julie Gordon and David Ljunggren; Additional reporting by Nichola Saminather in Toronto; Writing by Steve Scherer; Editing by Kirsten Donovan and Peter Cooney)