For several years headlines have warned of ‘inevitable’ interest rate hikes. But reality has seen interest rates drop steadily over the past several years, to new record lows. It is the opinion of most brokers – the front-line workers – that any increases in interest rates will be small and they will be gradual.
A key component often lacking from stories about potential interest rate increases is the actual math or impact of said increases. So I offer for you a cheat sheet outlining what eventual increases would mean to you personally.
Are you in a variable rate mortgage?
If yes, the Bank of Canada meets eight times per year (with the next meeting scheduled on Oct. 21st) in order to make a decision that will influence the prime interest rate on which variable rate mortgages are based. Very rarely does prime move by more than 0.25%.
What 0.25% means to a variable rate mortgage?
– Per $100,000 of mortgage money borrowed, a 0.25% interest rate increase for the typical mortgage holder would translate into a monthly payment increase of $13.
– $13 per $100,000 of mortgage money.
– Eventual increases are likely to come in 0.25% increments, gradually.
Tip of the day: variable rate mortgage holders can utilize prepayment privileges to increase their payment by at least $13 per $100,000 owed each year. Every penny of the immediate increase will be going straight to principal owed and will in turn reduce the amount of interest on every future payment. More importantly, you’re getting out ahead of any future rate increases and your payment will already be increased.
Being one, two or three steps ahead makes sense, call your broker about making a small increase today, to cushion you tomorrow.
Are you in a fixed rate mortgage?
On the upside, any immediate changes to interest rates will have no effect on your monthly payments or interest expense until your actual renewal date. Also on the upside, this gives you time to prepare for the potential of higher interest rates.
What 0.25% means to you will ultimately be much the same as the mathematics above. The risk is that instead of a slow, gradual rise, you may be in for a full 1% interest rate increase by the time your renewal rolls around. But that is okay, you have time on your side and your rate is fixed for now.
Key point; the mortgage balance you are renewing will be (in most cases significantly) lower than your original balance and thus the impact of an interest rate hike is that much less dramatic.
For example, a $300,000 mortgage on a 30-year amortization, taken at 2.59% today will have an ending balance five years from now of $264,613 (increase your payments each year and it will be lower still).
Renewing $264,613 at an interest rate 1% higher would increase the payment from $1,197.27 to $1,333.74.
Increasing your payment by 0.25% ($39 per month) each year would have you ahead of that curve-this is called the payment shock strategy.
In any event, this is an 11.5% increase in your payment. Five years from now, odds are your household income will have risen by at least $136.47/month.
This is not to say an increase of 1% is not meaningful, but with five years to prepare, it need not be.
In the event that interest rates continue to defy journalists’ and various analysts’ expectations, as they have done for the past six years, and remain low – while you increase your payment incrementally each year, then come renewal, you will truly be sitting in a plum position. Your mortgage payment amplified the point that your effective amortization will have reduced by several years and your mortgage balance will be decreasing at a more rapid pace than any mortgage balance has in the past 50 years.
Call your broker and talk about ways to take advantage of 50 year record low interest rates.
Jean-Guy Turcotte is a mortgage broker with Dominion Lending Centres – Regional Mortgage Group in Red Deer.