What If Interest Rates Double?

Every year, since always it seems, there are headlines warning us about interest rates.  Interest rates about to rise.  ‘Prepare For Interest Rate Shock’, being one of my local favourites, as the Bank Of Canada proceed to cut rates 0.25% the very next day.

The main problem with (all?) the headlines and the stories is that none appear to contain real math. Telling me rates are going to rise is like saying I’m going to get stung… ok but stung by what? A mosquito, a Zika-mosquito, A Bee, A Hornet, a Murder-Hornet, a Scorpion?!?! Help me out here, what’s the actual damage going to be? What does it all mean to me?

Well, here it is.  The missing math behind my own inflammatory headline;

What happens if interest rates double?

First off, double the rate does not equal double the payment.  Also, please note: A 25 year Amortization is used to reflect buyers with less than 20% down.

Today (July 2021)

Mortgage   Rate    AM    Term      Payment     Balance at renewal

$100,000     2%     25yr   5yr          $423.45       $83,770

Renewal Time (5 years from now)

If rates have doubled:

Mortgage   Rate    AM    Term      Payment     Balance at renewal

$83,770       4%     20yr   5yr          $506.00       $68,583

Let’s make the numbers more relatable. Let’s apply them to the average Canadian  household. Currently, in Canada, the average new mortgage balance is $400,000.

To qualify for a $400,000 mortgage requires not only down payment money, great credit, and well documented income. It takes $80,000 of gross income to qualify for $400,000.

Based on an exceedingly rigid stress test introduced in 2018, the maximum mortgage payment this household qualifies for today is approximately $1,700.  $1,700 set against a monthly gross income of $6,666.

But we don’t live in a world of gross pay, so… more math.

$80,000 is taxed at ~25%, leaving our borrower with $60,000 net, or $5,000 cash-in-hand each month. That $1,700 payment leaves our borrower with $3,300 to cover groceries, and other necessities.

Essentially, just 25% of pretax income is being used to service the mortgage payment. This significant cushion relates to a ‘stress test’ introduced by the federal government to protect you from yourself, despite there being no evidence at all to suggest that you needed such protection.

The byproduct of this ‘stress test’ has been to effectively push home ownership out of the reach of the lower middle class, and to exacerbate the wealth gap and essentially widen it to the point that it is nearly impossible to jump, or bridge with existing policies… but I digress.

Back to the fate of our borrowers with the 400,000 mortgage and rates doubling…

We need to ask a key question; Five years from now what will their income be?

They’ve started out the mortgage at $80,000 gross income.

Is it plausible they’ll receive a 1% raise each year?

If so, then $84,000 gross income leaves them with $62,500 net.

This is ~$200.00 more per month.

So; What if rates double?

At renewal, with now just 20 years left on the mortgage, a new rate of 4% pushed the payment to $2025.00

A 325.00 increase.

Our homeowner is effectively squeezed by $125.00 per month. But keep in mind, that the $125.00 is flowing from a $3,300 cushion

Ask yourself, is a family with an $84,000 household truly going to have difficulty with a $2025 per month mortgage payment?

Odds are that this same household is paying rent today somewhere between $2,200 – $2,500 already.

I think we can see the answer.

So, if fixed rates were to double at renewal – plausible for sure, perhaps even probable – will there be ‘blood in the streets’?

No. It’s just not that big a deal, as you can see.

But what if they triple?

Stay tuned, that math will follow in another segment.

And yes, this was all based on fixed rates, and no, I’m not a fan of fixed rates. Fixed rate mortgages, in particular 5 year terms, or worse a 7 or 10 year term, do more financial damage to Canadian households than just about any other needless expense.

Prepayment penalties are sorely misunderstood; not just by consumers, but by people who work at financial institutions themselves.

Life is variable, perhaps your mortgage should be too.

Contact your Expert Broker for the whole story.