Interest Rate Impacts on Credit products
Interest rates across the globe have shifted in the upward direction since historically low rates in 2020-2021. Mortgage rates were in the 1.9-2.5% range in 2020, now the average fixed mortgage rate on the street is 6.20%, making the cost of borrowing less favourable for the home buyer and/or Investor. Borrowers that locked in those rates for 2-3 year terms will have renewal payments that are going to be significantly higher once the term rolls over into a new rate.
For example, let’s say you have $100,000 for a down payment on a $500,000 property, which will mean you finance the remaining through a mortgage of $400,000. If you enter a 25-year mortgage on a property at 2.4% over a 3 year-term, your payment will be in the ballpark of $1,772.01. Over that term, you will pay $36,386.786 in principal and $27,405.37 in interest.
When your term renews, there will be 22 years of amortization remaining and a remaining balance of $363,613.14. This will be the amount owing to the financial institution following the first term.
Assuming a 6.0% interest rate at renewal, the mortgage payment has increased to $2,467.95. That is a $695.94 increase to your household fixed expenses! That means nearly $700 of disposable income has been removed from that household. Homes with a very high Loan-To-Value mortgage on their property and tight debt coverage on their financial products will have to reassess household budgets when the shift in rates starts to settle in.
Currently, the Canadian economy is overheated with record high inflation, significant increases in property values and low unemployment rates. To cool down the economic expansion, and cool off the inflation, the Central Bank of Canada stepped in via open market operations and sets the overnight interest rate. Increasing rates make it far less favourable to borrow money to invest in new projects, purchase goods using debt and buying property using excessive leverage. Major financial institutions in Canada borrow their funds from the Bank of Canada, so when the BoC increases their rate, it trickles down to the customer almost immediately.
Variable products are the financial debt products that are based off a market reference rate, sometimes referred to as “Prime”. Variable products are usually priced on a Prime+ basis, making your overall debt more expensive when the prime rate moves upward. Almost all lines of credit, whether they are secured or unsecured will be priced on a Prime+ basis. Even if you may not have a large term mortgage on a property, if you have a large balance on the property’s Equity Line of credit, you will be in for a larger than normal monthly interest obligation.
When assessing debt terms in a high interest rate environment, it may be worthwhile to enter a variable rate mortgage if your mortgage agent suspects that the prime rate will be going down soon. If rates are high but are also expected to continue going up, it would likely be favourable to enter a fixed rate for a medium term. If we ever enter a period of 1-3% mortgage rates, lock those terms in for as long as possible.
A lot of realtors will say “Date the rate, marry the house” as in the rate on your mortgage will fluctuate, but the house will be same at the end of your mortgage term. In a sense, the statement is true but is assuming that interest rates will come back down by next renewal. Financial professionals can run scenarios and make educated guesses about where they think interest rates will go, but only the Bank of Canada decides where they set rates and will do what they can to avoid excessive inflation.
The Bank of Canada follows an inflation targeting regime, meaning they adjust the interest rates in relation to the cost of living in Canada. The inflation tracker is measured the Core Consumer Price Index (CPI) which has a target of about 1.5%-2.00% annual growth. When inflation is running red hot and exceeds the CPI target, the economy is overheated as the cost of goods and services is driven higher by cheap credit and demand outpacing supply.
Overall, an upward shift in interest rates helps ease the inflation burdens the entire Canadian population and is viewed as favourable for depositors. For retirees and soon to be retirees, the higher market interest rate means higher returns on your portfolio’s risk-free assets such as Guaranteed investment Certificates (GIC’s). For households that are carrying a heavy debt load with products on a variable rate or fixed products nearing maturity, be prepared for a tighter household budget and less disposable income. Profit margins will shrink for businesses that carry significant leverage on their property, plant and equipment as interest expense will be driven upward without an offsetting increasing in revenue.
Speak with your personal financing planner, mortgage advisor or mortgage broker about what your options are and weigh the pros and cons of each scenario. If the home purchase or property investment does not make sense for your situation, continue to keep your eyes on opportunities that align with your financial strategy and needs.
