What If Interest Rates Triple?

What If Interest Rates Triple?

Rather than make noise about how ‘rates can only go up’ – which is a ridiculous statement.

Rates can go any one of 3 ways at any time; up, down, or flat. And when they do move, it is typically in small increments.

Although I guarantee you, some media outlet will write the headline ‘100% increase’ or ‘Interest Rates Double’, when the Bank of Canada moves the over night rate from 0.25% to 0.50%.

A 0.25% move represents and increase of about $50.00 per month on a $400,000 mortgage. Pretty minor.

But technically, such a headline would be accurate, it’s too good not to use.

It’s a bit like you curling a 1lb weight, and then going to 2lbs. Technically, your headline/post can be ‘100% increase’ but in reality, it means very little.

OK, Let’s get down to it and do the math around my own inflammatory headline;

What happens if interest rates triple?

Does triple the rate mean triple the payment?

No.

Note; A 25 year AM is used both to be conservative and to capture the 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 tripled:

Mortgage   Rate  AM    Term      Payment     Balance at renewal

83,770            6%       20yr    5yr            $596.00         $71,033.00

Let’s apply this math to the average Canadian household.

Currently, in Canada, the average new mortgage balance is $400,000.

To qualify for a $400,000 mortgage requires a down payment, great credit, and perhaps most importantly – well documented gross income of $80,000.

Thanks to an extreme stress test introduced in 2018, the maximum mortgage payment this household qualifies for today is ~$1,700, set against a $6,666 monthly gross income.

We don’t live in a world of gross pay though, so after the 25% income tax hit, our borrower is left with $60,000 net, or $5,000 cash in hand each month.

The opening $1,700 payment leaves our borrower with $3,300 to cover insurance, gas, groceries, and other life expenses.

To go further, we need to ask a key question; Five years from now, what will our borrower’s income be?

The day they closed on their new home, their income was $80,000.

It is plausible that they will receive a 1% raise each year?

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

This is ~$200.00 more per month.

What if rates have tripled?

Staying on track to pay off the mortgage in 20 years, at a new rate of 6%, the new payment is $2,400.00.

An increase of $700.00 per month.

Wait, that is not the end of the world. Let’s do a quick reality check. Odds are, an individual making $80K (or a family making $80K) is in fact paying rent today of $2,200 – $2,500 per month anyways. So, as a percent of income, this figure is not totally out of reach.  Not at all.

Let’s also recall that our borrowers had $3,300 per month cash in hand after tax and after mortgage payment – with no raise factored in, and living on $2,600 per month, rather than $3,300 is a big shift.

But it’s an unlikely one, because what is it that drives interest rates up again?

Some might say inflation.  Sure, that is a sign of a healthy growing economy. And generally speaking, rising interest rates relate to business picking up, and most likely wages as well.

Thus, with the 1% annual raise, our borrower isn’t taking a $700.00 hit at renewal. The raise offsets it to a $500.00 increase.

However, in a 6% interest rate world, it is plausible the raise may be more reflective of a 2% bump.

$80,000 with a 2% annual raise $88,326

$65,410 net

$5450 per month

A $450.00 net raise to offset a $700.00 per month payment increase. This borrower would still have $3,050 cash in hand after their mortgage payment and after taxes each month.

Ultimately, a mortgage payment increase of $700.00 for our average borrower is unlikely, as is rates tripling to 6% at renewal, along with zero wage increase for 5 years. But even in that extreme analysis, there is still a healthy cushion here.

It is far more likely that reality is somewhere in the middle, with an interest rate increase that moves the payment about the same amount as the take home pay moved.

The bottom line is that it will take more than a few hikes in interest rates to cause any notable damage to the Canadian Real Estate market.

A footnote that deserves to be more than a footnote; What are the primary causes of foreclosure in Canada?

About 1 in 300 mortgages in Canada goes to foreclosure. And 3 in 4 of them are mortgages on investment properties, which represent about 4% of the average lenders’ books.

Imagine a product that represents 75% of your headaches – I bet you would make obtaining that product very difficult. And that is what has happened.

What about the 1 in 1,200 that are owner occupied? The same old same old – The three D’s – death, disability, and divorce.

Or a combination thereof.

Two of the three D’s you can insure yourself against for a very little per month in most cases. Have you tackled your insurance?

The third D, what’s the insurance against that one? Well hey – how much does it cost to say ‘I Love You’ three times a day?

And yes, the above was all based on fixed rates, and no, I am not a fan of fixed rates.

Fixed rate mortgages, in particular 5 year terms, or worse 7 & 10, do more financial damage to Canadian households than just about any other financial product.

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.