Yes, we’ve had years of relatively low and stable interest rates in Canada, but no more. On October 24, 2018, the Bank of Canada increased its benchmark interest rates another 25bp to 1.75%, the fifth increase since mid-2017 for a total increase of 1.25% above its historical lows.
Your reaction might be “so what?” Rates are still relatively low. An increase of another .25% is no big deal, right? That may appear to be a small number, but here’s what it means in real life:
If you have a $400,000 mortgage, amortized over 25 years, at 2.59%, your monthly mortgage payment would be $1,810 per month.
That same $400,000 mortgage at 2.84% would cost you $1,860 per month.
That’s an increase in your monthly mortgage payment of $50 a month.
Multiply this by the 5 rate increases we’ve seen, and you are facing a possible increase in your mortgage payment of $250 a month.
With so many Canadians living paycheque to paycheque, this is going to be a shock. Yet, we shouldn’t be surprised.
In 2012, I was interviewed on CBC Radio’s The Current, on a segment about Doubting Personal Debt and we discussed, even way back then, that debt is a “ticking time bomb”. Back then I warned that low interest rates were making our debt artificially ‘affordable’. I made the comment that we could be in trouble if interest rates rise.
And on the same day in October 2018 as the Bank of Canada increased rates to the highest since December 2008, I was once again on CBC Radio’s The Current to talk about Canadian debt as part of a special they were calling Debt Nation.
When facing a rising rate environment, you need to consider what an increase in interest rates will do to your personal cash flow.
For many years the best decision a Canadian could make was to get a variable rate mortgage (not a fixed rate), because the rate was lower. That’s great, but a variable rate, obviously, is variable, so it can go down, but it can also go up.
Today you may be paying 3% on your variable rate mortgage, so on a $200,000 mortgage amortized over 25 years you are making a monthly payment of $946.40 What happens if your variable interest rate was to increase by 1%? Again, you may not think 1% is a big number, but a 4% interest rate on your $200,000 mortgage amortized over 25 years would cost you $1,052.04 per month. Can you afford to pay an extra $105.55 per month on your mortgage? Will your after-tax pay cheque be increasing by $105 per month this year? If not, higher interest rates will squeeze your budget.
Here’s where most people miss the point: going from a 3% to 4% interest is not an increase of 1% in your payments. If your rent goes from $300 to $400 per month, how much did your rent increase? Answer: one third, or over 33%.
That’s the point: if your interest rate increases by 1%, the actual interest cost of your mortgage in the example above increased by over 33%.
That’s a huge increase, and unless your pay will also be going up by 33%, higher interest rates will be a problem for your monthly cash flow.
Will my mortgage rate increase?
If you have a variable-rate or adjustable-rate mortgage, the answer is yes. Your mortgage lender will increase your borrowing rate. Whether your monthly payment increases will depend on the terms of your variable rate loan. If you have a fixed payment for the remainder of the current term of your mortgage (not to be confused with a fixed interest rate) your payment may stay the same, but the amount of your payment that goes towards interest, rather than principal, will increase. This can be very costly. Not only are you paying more interest while rates are higher, but you’ll also pay more interest over the remaining life of your mortgage. Paying less principal now, means you have more principal on which the bank can charge you interest this month, next month and the month after.
Mortgage term – a mortgage term is the length of time in which the conditions of your mortgage, like your interest rate and amortization period, don’t change. For example, your mortgage term may renew in five years.
Mortgage amortization period – is the time period it will take to repay your mortgage in full, under the current conditions of your mortgage term. The amortization period is used, in combination with your interest rate, to determine your payment. For example, your payments may be based on a 25-year amortization period.
If you have a fixed-rate mortgage, the terms of your loan mean that your interest rate remains unchanged for the remainder of the term. That means that your interest rate, and payments, won’t immediately increase when interest rates rise. You will, however, be facing higher rates on renewal.
What happens to my Home Equity Loan (HELOC) or Line of Credit?
If you have a home equity line of credit or unsecured line of credit, you will see an immediate increase in both your interest rate and monthly minimum payment. Many people are shocked to hear that their financial institution can change the rate on their variable rate lines of credit overnight however those are the rules under the loan agreement.
What about fixed-term loans like my car loan?
Term loans have set loan conditions, including your interest rate, for the life of the loan. So if you purchased a car with a six-year car loan, your rate, and monthly payment will remain unchanged even as interest rates rise. However, if you refinance after buying a new car, or enter into a new lease, you will be purchasing during a period of higher rates.
What happens to my student loans when rates rise?
Again, this depends on whether your student loan is a fixed-rate or variable-rate loan. If you have a fixed rate student loan, whether private or government guaranteed, you won’t see an immediate increase in your monthly payment or interest costs. If you have a variable-rate loan, both your interest rate and minimum payment will rise.
Will my credit card rate increase?
Most people we work with have a fixed-rate, high interest, credit card with a typical rate in the 19-22% range. Rates on these types of cards do not typically change when interest rates rise. Just like they don’t decline during periods of low rates. If you have a variable-rate card, however, your rate will increase. The best way to avoid interest charges on credit cards, no matter what rates do, is to pay your balance in full each month.
What can you do when interest rates rise?
Here’s my advice: don’t assume interest rates will remain stable for a while. If one bank has started increasing rates, it’s likely that other banks will follow, so it’s time to consider what you will do if interest rates rise, and make a plan NOW to deal with further potential rate increases.
- Now is the time to make a plan to reduce your debt as much as you can.
- You may want to explore switching from a variable-rate to a locked in fixed-rate mortgage or loan to create some certainty regarding your financial payments. Talk with your lender or a mortgage broker to see what kind of rates you can refinance at but don’t forget to factor in any penalty. Know that, in a rising rate environment, variable rate loans are riskier.
- You may also want to consider shortening the amortization period on your mortgage to pay it off sooner or switching from monthly to bi-weekly or weekly payments to accelerate your payments and become mortgage free faster.
I can’t predict the future, so I don’t know how much more interest rates will rise but it’s likely we are facing down a few more increases over the coming months. I can, however, advise you to consider all options so that you are prepared regardless of what happens to interest rates.