Could your household withstand a 125-per-cent increase in interest rates? It’s a question you should look beyond averages to answer, as it could mean the difference between living the homeowner’s dream and having that dream turn into a cash-flow nightmare.
The Organization for Economic Co-operation and Development recently suggested that Bank of Canada governor Mark Carney should raise interest rates by 0.25 per cent for five consecutive quarters starting this fall. The rationale was that these laddered increases would head off rising inflation as well as help to cool the country’s housing bubble.
The headline interest rate is 1 per cent, so an increase to 2.25 per cent is a relative 125-per-cent increase in rates.
But as we continue to peel back the unending layers of problems in Europe, the increasingly bleak global plight makes that easier said than done. Despite the OECD’s eloquent report, predicting interest rates is nearly impossible because the decision factors are constantly changing.
That being said, it’s prudent to plan for the worst and hope for the best. So what would such a hike mean to the average Canadian?
Well, in the end, using averages might not make too much sense. The only way to see how it will affect your own household cash-flow situation is to run some simple numbers. For those who have their debt under control, a schedule of rate increases as dramatic as suggested here won’t be much of a stretch. For others, it could get ugly.
Human Resources and Skills Development Canada reported that the median, after-tax income for couples with children was $75,600 in 2009. Incomes haven’t grown much since then. If you apply a statistic that has been getting some headline news lately – the total debt-to-household-income ratio, which stands at roughly 150 per cent – that means the average couple might be looking at $113,400 in total debt.
The bulk of that might be in the mortgage, with some line-of-credit and credit-card debt thrown in for bad measure. (Sorry, I couldn’t use “credit-card debt” and “good” in the same sentence.) Crudely, if their overall interest costs were 7 per cent, maintaining that debt would cost roughly $7,938 a year. The mortgage might be cheaper than 7 per cent, but the credit cards could be north of 20 per cent, remember.
If that 7-per-cent average interest rate were to increase to 8.25 per cent, the cost to carry $113,400 increases to $9,355.50. That’s a difference of $1,417.50 a year, but most people think in terms of monthly payments. In that case, it’s an extra $118.13 a month.
If you have a fixed-rate mortgage, you won’t see a change in payments until your term is up. So you might have some more breathing room on that front (although you’ll feel it when it comes time for renewal).
Let’s be frank: I don’t know many people my age with a household income of essentially $100,000 a year who have less than $250,000 outstanding on their mortgage. Averages really don’t give you a good idea of how this will unfold for your situation. You have to work through your numbers yourself to get a handle on it.
Take this scenario of a young urban professional couple who make $125,000 a year and recently bought a $420,000 condo with a small down payment a few years ago. Let’s say they have a mortgage of $380,000, fixed at 4.2 per cent with their term ending at the end of next year. They also have $7,500 in credit-card debt at 18.8 per cent that they can never seem to pay off.
An interest-rate increase of 1.25 percentage points, and a letter from their credit-card company indicating that its rate is going up to 21.5 per cent means they are looking at an increase in payments of about $3,278.40 a year by the time they renew their mortgage for the next term.
The lesson here: Even if you consider yourself in an “average” situation, the devil can be hiding in the details.
A snapshot of a couple that doesn’t fit the “average”
Starting in 2012 $380,000 mortgage @ 4.2 per cent, with a 27-year amortization left, and two years until the current term expires. Monthly payment = $1,954.93
$7,500 in credit-card debt @ 18.8 per cent interest. This balance hovers at the same level over time. Monthly interest cost = $117.50.
Total = $2,072.43
2014, time to renew the mortgage The couple still have about $364,000 remaining. To maintain the same target date for paying it off, they now have a 25-year amortization, but the best fixed rate they can get is 5.45 per cent. Monthly payment = $2,211.25.
The credit-card company increased the rate its charges to 21.5 per cent. The couple still isn’t able to pay it down. Monthly interest cost = $134.38
Total = $2,345.63
Difference = +$273.20 a month, or $3,278.40 a year.