On January 17, 2018 the bank of Canada has raised interest rate for the third time since the downward trend shifted in the summer of 2017 to 1.25%. Some economists are expecting this trend to continue. This has increased the cost of borrowing for many Canadians. Now would be a good time to revisit amounts you have borrowed and re-evaluate your budgets to verify if you are living within your means.
The Bank of Canada overnight lending rate was over 8 times higher 10 years ago and there had been an overall decreasing trend over the past decade leading up to this summer. It will be important to consider the affordability of all debt in the coming years as interest rates increase to levels prior to the economic collapse of 2008, which is a reasonable possibility over the next number of years.
The Parliamentary Budget Officer (PBO) has warned “the financial vulnerability of the average household would rise to levels beyond historical experience,” based on his projections about interest rates, household debt and debt servicing costs. According to those forecasts, if the Bank of Canada were to raise the key interest rate from the then 0.5 percent to 3 percent, as is expected by mid-2020, the average Canadian family would have to use 16.3 per cent of its disposable income for debt repayments by the end of 2021.
With the interest rate increase having some level of predictability, it would be a prudent time to revisit debts you have accumulated and re-evaluate your finances to verify if you are and will continue to be living within your means. It is advisable to seek professional advice on how to best manage your household budget.
If you have a fixed rate mortgage – there will be no changes for the remainder of your term. However, you should prepare for a likely increased rate when your mortgage is up for renewal. It is important to look ahead to the renewal and understand how your household will manage the increase in monthly mortgage cost. The interest rate on mortgage debt could climb from to 4.8 per cent by the end of 2021, according to the PBO. This will affect homebuyers who use financing. At 4.8 percent, the interest on mortgage debt would still be below Canada’s long-term average of 5.4 percent, as noted by the PBO.
Variable rate mortgages are by definition exposed to any fluctuation in interest rates – for better or for worse. The cost to service variable rate mortgages has immediately gone up as a result of the increase in interest rates. With some variable-rate mortgages, payments remain the same for the duration of the term. But there are adjustments going on in the background. As rates rise, more of your payment goes toward paying interest and less goes toward the principal. This will increase the amount of time it takes to pay off your mortgage unless you increase payments on renewal.
You may have an option to convert your variable rate mortgage to a fixed rate mortgage, which would help in longer term budget planning, however may overall carry a higher cost.
It has become tougher to qualify for home ownership. Federal rules now require all home buyers to “stress test” their ability to carry mortgage payments at whichever is greater: the negotiated rate in their mortgage contract (which is 2% higher than the rate you will be paying) or the Bank of Canada’s conventional five-year fixed posted rate.
HOME EQUITY LINES OF CREDIT (HELOC)
Most HELOC’s are a variable rate loan. While a relatively easy and convenient way to borrow, HELOCs can be habit forming and take years to pay back. Also the terms of these loans are less favorable for long term planning, are intended for short term requirements and can be quite costly in administration. It is very important to assess the impact of the increase in interest rate on your HELOC and particularly, ensure that your debt as a percentage of your home value is as low as possible reducing your household to fluctuations in both interest rate increases and changes in home valuation.
OTHER LINES OF CREDIT
Lines of credit often carry variable rates. When such credit lines are unsecured against any asset, such as your home or car, the interest rates can be higher and rate increases can create even greater stress on payment requirements. It would be advisable to reduce any reliance on such unsecured lines of credit.
Your payments will likely stay the same as most auto loans have fixed payments, whether your rate is fixed or variable. Your loan repayment period will stretch out if you have a variable rate with payments staying the same, however it will take you longer to pay off your loan.
Credit cards generally charge interest at a fixed rate. Although that fixed rate can be quite high, it won’t increase with the Bank of Canada’s overnight rate. Some credit cards do charge variable interest rates, so check the specific terms and conditions of your card to be sure.
Even if your credit card’s interest rate is fixed, that’s no reason to be complacent about credit card debt in any interest rate environment. If regular credit card payments are missed (perhaps because the cost of making their other debt payments has increased) some credit cards will actually raise the interest rate owed on the outstanding balance. Ultimately, credit card debt is something to be avoided with many horror stories of credit card debt becoming unmanageable due to the high and punitive interest rates.
Government student loans don’t require payment until six months after leaving school, although they do accrue interest during that period. The rates can be either fixed or floating. Either way, Canadians who are about to start repaying their student loans will be affected now that the Bank of Canada has increased rates, according to Campbell. Floating-rate student borrowers will see their interest rate go up immediately, while fixed-rate borrowers will have to lock in their payments at a higher interest rate than they would have.
Student loans may also be available at no interest until six months after graduation. This little to no interest period should be taken advantage of, however a plan should also be in place to pay down this loan over a reasonable amount of time.
With the changing trend in interest rates after a significant time – consumer appeasement towards debt will need to change. Borrowing will become more expensive and additional reflection should be taken towards incurring such commitments. There are positive aspects to debt and access to good financing is a strong tool towards personal and community advancement. A well thought out plan to source, maintain and repay any debt should be in place and reviewed regularly.
Nizam Shajani, CPA, CA, MBA
ROB CARRICK, JEREMY AGIUS AND MATT LUNDY; THE GLOBE AND MAILLAST UPDATED: WEDNESDAY, JUL. 12, 2017 3:08PM EDT
Erica Alini National Online Journalist, Money/Consumer Global News
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