What would a 2% mortgage hike do to the housing market?

Canada's housing market would be more than able to withstand a modest two per cent increase in mortgage rates as long as it's implemented slowly, over a year or two, BMO economist Robert Kavcic says.

In a report Friday, Kavcic runs some numbers trying to gauge the impact of what would happen if Canadian mortgage rates increased by about two per cent.

The housing market has been pumping out strong gains for more than a decade, which has caused policymakers and many private-sector observers to worry that prices are too high, and think a correction has to be coming — especially once mortgage rates return to more normal levels.

But there isn't necessarily anything to worry about in a modest, two per cent hike, Kavcic finds — depending on how it's implemented.

Most first-time homebuyers in Canada choose a five-year fixed-rate mortgage amortized over 25 years, so that's the baseline that Kavcic works from. (Currently, the average posted mortgage rate for that type of mortgage is something around three per cent.)

In order to gauge affordability, Kavcic looks at the same metric that financial planners say buyers should pay attention to when buying a home — the percentage of the buyer's income that gets eaten up by housing. (A healthy level is when 25 to 30 per cent of one's income is spent on housing. Borrowers historically run into trouble when that ratio hits 35 per cent or higher.)

Kavcic says if mortgage rates jumped by two percentage points overnight (say, to an average of around five per cent) the impact on the housing market would be dramatic, as people would suddenly finding themselves paying a dangerously high percentage of their income on housing.

"If we were to get that increase overnight, housing valuations … would be stretched to levels that preceded significant corrections in the past," Kavcic says.

But if that two-percentage-point increase gets implemented a little more slowly, giving incomes times to catch up, the impact is much less dramatic. If the hike is implemented gradually, until 2016, the income ratio doesn't go into the danger zone, he says.

As well, if the hike is even smaller, something around one per cent, there could actually plenty of room for prices to go up further. "If that increase happens gradually over the next two years, if at all, it's a much different story," Kavcic said.

His assumptions are based on incomes rising by a modest three per cent per year over that time, a reasonable assumption based on the 3.1 per cent pace that Statistics Canada says they're increasing by right now.

The latest data from the Canadian Real Estate Association shows the average Canadian home price hit $409,708 in April, up more than 7.6 per cent in the past year.

Most experts think the days of outsized gains have to come to an end some day soon, but as Kavcic's analysis shows, mortgage rates ticking higher but slowly should be no reason to spark a major sell-off.