Rising interest rates and debt: what you need to know
No matter where you are on the pay grid or what your pension income is in retirement, rising interest rates are making everyone’s debt load more expensive to carry.
They’re also making people feel very nervous.
According to a recent survey, 35% of Canadians fear that rising interest rates could actually push them into bankruptcy. With the key lending rate starting to creep up for the first time in over two years, it’s safe to say that now is definitely the time to start reviewing your budget—particularly if you have a mortgage renewal coming up within the next 12 months (as there are further rate increases expected throughout the year ahead).
What does a rate hike mean for current fixed-rate mortgage holders?
If you have a fixed-rate mortgage, you can relax for the time being.
Just keep in mind, depending on how soon renewal time is for your mortgage, that rates will most likely be higher than the last time you locked in—which could impact your monthly budget.
For example, if the remaining balance of your mortgage is in the ballpark of $200,000 to $400,000 and there is a 1-2% increase from your current rate after renewal, your mortgage payments could cost you $200 to $400 more per month. While rising interest rates are a reality of the ups and downs of an ever-changing market, there are ways you can get ahead of rising rates before your own mortgage renewal time.
If you have a variable-rate loan and/or mortgage, you’re already paying for the most recent rate increase.
While the upside to variable-rate loans is that interest rates tend to be lower than those with a fixed rate, the downside is that with every BoC rate increase, you instantly pay more for those variable loans and mortgages each month. That’s because the interest rate for variable-rate loans are calculated as the prime rate (the rate which lenders use to set interest rates for variable loans and lines of credit) plus or minus a certain percentage. The prime rate is heavily influenced by the BoC’s policy interest rate (also known as the overnight rate) so when the BoC raises the overnight rate, the prime rate goes up, too, and in turn, increasing your variable-rate loan.
To put the latest rate increase into perspective, let’s say you have a $400,000 variable- (or ‘adjustable’) rate mortgage amortized over 25 years and that your variable rate over the last year was hovering at about 1.15%.
Prior to the March 2 rate hike, your monthly mortgage payment would have been $1,534.
After the 0.25% hike, your variable rate would have jumped from 1.15% to 1.40% and your monthly mortgage payment would have increased to $1,580—a difference of $46 a month, $552 a year, and $13,800 over the course of 25 years. As rates continue to increase, those numbers will get even higher.
50%: the percentage of Canadians who are just $200 away from not being able to pay their bills
How do rising interest rates impact first-time home-buyers?
Besides having to pay higher rates than those who entered the housing market a few years ago, there’s also the mortgage stress test to factor in.
A refresher on the mortgage stress test:
- It was introduced by the Office of the Superintendent of Financial Institutions on January 1, 2018 as a way for home buyers to prove they can afford higher interest rates
- This means buyers who apply for uninsured mortgages with a down payment of 20% or more, or those buying homes worth $1 million or more, would have to be ‘stress-tested’
- The test aims to show which home buyers could afford a mortgage either at the 5-year average posted rate, or two percentage points higher than the bank/brokerage rate(whichever one is higher)
- Since the stress test came into effect, buyers have needed an average of $28,750 more than they did prior to Jan.1, 2018 to qualify for a mortgage (according to Mortgage Professionals Canada)
- Every time the BoC raises its key lending rate, the benchmark rate for the mortgage stress test also goes up—affecting whether or not potential home buyers get approved for the mortgage they want
Here is the $64,000 question: how do you get ahead of rising interest rates when it comes to your debt?
1. Start by paying down debt of the ‘variable’ kind.
Interest rates are steadily climbing, with more rate hikes expected to come. If you have a mixture of fixed- and variable-rate debt tied to prime, consider creating a plan to actively pay down your variable-rate debt first. This will reduce the immediate impact that each rate hike will have on your finances.
However, if your fixed-rate debt load is substantial (such as high-interest credit cards), you may want to focus on paying that down first, depending of course on how much you owe and how high the fixed rate is.
2. You should consider converting from a variable to a fixed rate.
If rising interest rates have your stress levels rising, you may want to consider fixed rates (and the peace of mind that they provide), particularly since the financial forecast calls for further rate increases over the course of the year.
When it comes to converting from variable to fixed, however, be aware of the conversion rate offered by your lender. This is the cost of switching, and tends to be higher than what new borrowers would pay.
To decide whether or not it makes financial sense to make the switch from variable to fixed:
- Evaluate the conversion rate being offered by your lender
- Factor in the number of years left in your current term, and any further interest rate hikes projected within that time frame
Also be aware of any term limitations.
When converting to a fixed rate, most lenders require you to choose a fixed term that’s at least as long as the term remaining on your variable-rate loan. Furthermore, some lenders may only let you lock into a 5-year fixed term, which is fine if you’re looking for that longer-term commitment. However, keep in mind that should you need to break the mortgage before the five years are up, you may have to pay additional costs. There may also be refinance restrictions, so be sure to ask for full disclosure on all of the ‘fine print’ before signing and ask for everything in writing.
3. ‘Stress-test’ your finances by conducting a future budget exercise.
While the stress test is a mandatory exercise in order to qualify for a mortgage, the concept of ‘stress-testing’ your finances can also be used as a way to gauge how future rate hikes could potentially impact your cash flow or your ability to pay down debt. This is where a budget calculator comes in handy. Use it to estimate how much financial room you have to accommodate increased debt payments that could arise due to further escalating interest rates.
Do rising interest rates have you feeling nervous? Call on Educators Financial Group for a little peace of mind.
From a sound financial plan to help you conquer debt and save more efficiently, to smart borrowing options at rates offered exclusively to education members and their families—let us help you achieve the financial future you always dreamed of.
Have one of our mortgage agents contact you to put your financial plan into motion.
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