Homebuyers could be lulled into taking on larger mortgages than they can handle because of continued record low interest rates, says the C.D. Howe Institute.

The Ottawa-based public policy think-tank says many economists, including its own, are predicting rate hikes as much as a full percentage point or more later next year.

"Does the simple experience of short-term interest rates being so low, for so long, encourage people … to mortgage themselves more than they otherwise would, and buy a bigger house than they otherwise would … and get themselves into trouble longer term?" said C.D. Howe president and CEO William Robson.

On Tuesday, the Bank of Canada announced it would keep its key overnight rate at the historic low of 0.25 per cent. The C.D. Howe Institute says that is helping to create a false sense of security among borrowers who have taken on debts larger than they could normally afford.

Robson said a rapid rise in interest rates could prove devastating for homeowners who have not evaluated their ability to carry their mortgages at a higher interest rate.

The institute's monetary policy council has predicted the overnight interest rate will rise one percentage point in the second half of 2010.

The council said the central bank should give a strong signal that an eventual overnight rate move may be quick and large. It also suggested the bank rein in the housing market by raising the required down payment on government-insured mortgages.

Risk of a bubble

Robson believes the Bank of Canada's preoccupation with the high exchange rate is encouraging people to think the overnight rate is going to stay low longer.

"The Bank of Canada's OK with that because they see that as important to stimulate the economy. But if you look at the housing market you have to wonder, are we seeing too much of a good thing?" he said.

Cameron Muir, chief economist at the B.C. Real Estate Association, said low interest rates have played a key role in home sales, which have rebounded dramatically compared with the beginning of the year, but he too forecasts that long-term and short-term mortgage rates will edge up in late 2010.

"In the next 12 to 18 months, it's likely that rate is going to start heading higher and it's going to have an impact on those consumers who have short-term variable rates and home equity lines of credit," Muir said.

Robson said there is risk of a housing bubble stemming from interest rates set too low. "People are getting a little bit too used to this emergency low on the overnight rate," he said.

With files from The Canadian Press