Introduction: A Trip Down Memory Lane and Lessons from the Past
When I entered the advisory world in the early ’90s, mortgage interest rates were nothing short of staggering by today’s standards. I remember purchasing my first house in 1991, opting for a five-year variable rate that was hovering around 9%. Believe it or not, that was considered fortunate timing. Just a year before, anyone locking in a mortgage would have faced a jaw-dropping 13% interest rate.
During the majority of my career, we’ve enjoyed a generally descending interest rate environment. Homebuyers in recent decades have been able to secure mortgages at rates that would have seemed unimaginable in 1991. But history has a funny way of circling back. With the recent uptick in mortgage rates, I find myself revisiting some invaluable lessons from those early years.
In a market climate that mirrors some aspects of my early days in the industry, I’m reminded that while numbers and percentages may change, the principles of wise mortgage selection remain constant. The importance of understanding one’s payment sensitivity is not a new concept, but it’s one that takes on renewed significance when rates are rising. After all, it’s not just about what your budget can handle today but also about how flexible and robust it can be in the face of future uncertainties.
The Mortgage Landscape Through the Ages
A Harsh Lesson from the ’80s: High Costs for Borrowers, High Yields for Savers The 1980s saw an environment of high inflation and volatility, which catapulted mortgage rates to an eye-watering 21%. This period was challenging for borrowers, increasing the cost of loans and creating financial strains. However, it was a golden era for savers and investors, who could garner bond yields ranging from 14% to 18%.
Years of Lowering Rates: A Comfort Zone We Entered
From the early 1990s until the pandemic hit, interest rates generally trended downward. This made loans more affordable and led people to grow accustomed to cheaper borrowing costs. On the flip side, those looking to save or invest had to adjust their expectations for returns, as lower rates meant lower yields.
The COVID-19 Effect: An Abrupt Turn in Monetary Policy
When COVID-19 disrupted economies globally, central banks like the Bank of Canada took dramatic action. They slashed rates nearly to zero, aiming to stimulate economic activity during the lockdowns and uncertainty.
Beyond Interest Rates: The Larger Economic Repercussions of the Pandemic
The impacts of the pandemic went beyond interest rates to affect other economic variables. Supply chain issues and fluctuations in the job market contributed to rising prices. In response, the Bank of Canada has started to gradually raise interest rates, affecting the landscape for both homebuyers and investors.
The Tide Turns: A New Financial Landscape in 2023
The Bank of Canada’s Financial System Review for 2023 serves as a wake-up call for borrowers, cautioning them to prepare for potential payment increases ranging from 20% to 40%. This announcement holds significance not just in isolation but as a part of a shifting financial landscape, marked by varying economic indicators. The warning is particularly relevant for those entering the property market for the first time and for existing homeowners considering mortgage renewals.
The Implications of a 6% Variable Rate on Mortgage Affordability and Payment Sensitivity
In the current financial landscape with variable rates hovering around 6%, mortgage renewals are increasingly becoming the focus of financial planning. This comes at a time when households have already stretched their budgets to enter the housing market, as noted in the Financial System Review—2023 report. The share of new mortgages with amortization periods longer than 25 years rose from 41% to 46% over 2022, further lengthening household vulnerability.
If your mortgage payment exceeds 32% of your gross household income under higher variable rates, it’s time to take action. As a rule of thumb, your debt service ratio (DSR) – your total monthly debt obligations divided by your gross monthly income – should stay below 40%. A rising mortgage payment can tip that ratio unfavorably, so take proactive steps if your DSR approaches or exceeds 40%.
With fluctuating mortgage rates, it’s important for borrowers to take a close look at their household budget. Make sure you have a full picture of your monthly costs like car loans, credit card payments, childcare, utilities, etc. This will help you realistically assess if you can afford higher mortgage payments if rates were to rise. Also re-evaluate your spending to see where you can cut back on discretionary costs to free up more room in your budget. Our exclusive webinar Following your Money Trail: Building an Effective Cash Flow Plan, is a valuable resource to assist you in taking a closer look.
Here are some proactive steps to consider:
– Consult a mortgage broker about alternatives like fixed rates, extended amortizations, blended payments, or special arrangements that may better suit your budget. Brokers can often negotiate options with your lender that you may not be aware of.
– Ask your lender about converting to a fixed rate or prepaying your mortgage while rates are still relatively low to avoid payment spikes. Review your mortgage contract for flexible options.
– Be cautious about payment deferrals – while they provide temporary relief, deferred interest gets added to your principal. This increases your interest costs over the long run. Explore deferral cancellation policies and other alternatives first.
– If necessary, consider adding rental income by taking on a roommate or renting out your basement to help cover higher payments.
The Core Question: Affordability and Payment Sensitivity in a Shifting Economic Landscape
The crucial question you should be asking yourself is: “Given my financial situation, can I afford a variable rate, and am I sensitive to potential payment increases?” Your decision should harmonize with your overall financial plan and take into account your capacity to manage possible payment spikes, particularly given the current economic indicators.
Smart Choices in a Changing Financial World
Interest rates are always moving up or down, and that affects us all. Knowing how to adjust your plans in response to those changes is crucial. A well-thought-out financial plan and a good grasp of the economic situation can guide you to make decisions that are right for you.
As we go through these shifts in interest rates, planning, flexibility, and consultation with professionals are your best strategies. By being prudent and well-informed, you can make decisions that stand the test of time.
1. https://www.canadianmortgagetrends.com/2023/05/mortgage-borrowers-to-see-payments-increase-by-20-40-at-renewal-bank-of-canada/
2. https://www.bankofcanada.ca/2023/05/financial-system-review-2023/
