Trivia question: What is the interest rate you're paying on your various debts?
Interest rates seem vitally important in a week in which the Bank of Canada raised its benchmark lending rate for the first time in seven years, but they're not what you should be focusing on as you prepare for the possibility of borrowing costs ahead.
"People get all excited about rates," said Stephanie Holmes-Winton, CEO of a firm called the Money Finder, which trains financial planners and advisers to better help clients manage their household cash flow. "But rates don't have a lot of impact until you add amortization and principal."
Amortization refers to the period of time over which you'll gradually repay what you owe, and principal is the amount you borrowed. Both, obviously, get at least a bit of attention when you set up a mortgage, line of credit or loan. But it's the interest rate that we obsessively research, negotiate, then brag about.
"We've been taught to chase the shiny thing," Ms. Holmes-Winton says of our fixation with rates. "It's so easy to say 3 per cent is less than four. What we're not looking at is the question: How much does my debt cost me?"
Want to protect yourself against the risk of higher rates? Pay down your principal and shorten your amortization. The more effective you are at reducing your total household debt load, the less vulnerable you are if borrowing costs gradually move higher in the months and years ahead.
Even in today's low-rate world, the cost of debt is substantial. Someone who buys a $500,000 house with a 10-per-cent down payment would pay $165,374 in interest if we assume today's discounted five-year fixed mortgage rate of 2.6 per cent lasts throughout a 25-year amortization. If the economy sustains current growth levels or improves, expect both rates and interest costs to be higher. With a constant 3.6-per-cent mortgage rate, total interest costs over 25 years rise to $236,707.
Let's say you have the average $70,000 balance carried by people with home equity lines of credit (HELOCs). Over a year, your minimum monthly payments (interest only) would add up to about $2,415 at current rates. Your principal remains at $70,000 if you just pay the interest on the average HELOC balance, and interest costs pile up endlessly. Higher rates aren't your problem if you're in this position; the bigger issue is the need to grind down your principal and get your debt paid off. Reducing your balance even to $50,000 cuts your annual interest bill to $1,725.
According to a recent study from the Financial Consumer Agency of Canada, some lenders find that a large majority of HELOCs are not fully repaid until the borrower sells his or her home. This kind of financial procrastination is possible only when interest rates are as low as they have been.
With a mortgage, the simplest way to reduce principal and amortization is to make payments on an accelerated biweekly basis rather than monthly. You're essentially making a 13th monthly payment each year if you do this. The benefit for people just starting a mortgage is an automatic reduction in amortization by roughly two years – 23 instead of the usual 25 – and a lower overall interest cost.
Paying down the mortgage principal is another tactic – one that we're pretty good at already. Data presented late last year by Mortgage Professionals Canada (they represent mortgage brokers) shows that 35 per cent of homeowners with mortgages used one or more of these measures in the past year to get their mortgage paid off faster: Increasing their payment, making a lump-sum payment or increasing the frequency of their payments. In cities where people are forced to take on big mortgages to buy a house, it would be great to see half or two-thirds of home buyers take at least one of these steps.
According to Ms. Holmes-Winton, the sad part of our rate obsession is that we often underestimate what we're really paying. She's found that people's average rate across all their borrowings – loans, mortgages, credit cards and more – is 8 per cent. Problem is, people seem to mistake much lower mortgage rates for their overall cost of borrowing. "People are paying way more average interest than they realize."