Taking action when interest rates rise
By Michelle Seymour, CPA, CA, CFP® 9 September 2022 5 min read
You don’t have to look far to find an article about rising interest rates and the impact on future mortgage payments. According to FP Canada’s 2022 Financial Stress Index, 19% of Canadians surveyed said that rising mortgage rates contributed to their financial stress. But homeowners don’t have to stand by and feel helpless as rates increase. They can take actions that will help address their situation and provide peace of mind.
Since the impact of rising rates will be unique to each individual or family, the best course of action will look different for everyone. We’ll take a look at a range of scenarios, including both fixed- and variable-rate mortgages, each with a corresponding case study, as well as the implications for those who are debt-free.
Fixed-rate mortgage with upcoming renewal
Prime interest rates rapidly declined at the onset of the pandemic in 2020. Those with an existing fixed-rate mortgage will not have benefitted from these lower rates, unless the mortgage was renewed during that time. On the other hand, as rates have risen in 2022, those with a fixed-rate mortgage will not have seen a rate increase. Fixed-rate mortgages provide rate certainty throughout the mortgage term as a rate change will only occur at renewal.
Case study: Brandon and Jeff
Brandon and Jeff purchased their first home 10 years ago and last renewed their mortgage in 2017. During this time, they have consistently made their required principal and interest payments but have chosen not to use any prepayment options. Unlike their previous mortgage renewal, Brandon and Jeff were somewhat anxious about their upcoming renewal in light of rising interest rates.
They discussed these concerns with their mortgage specialist and considered two options: 1) Increase their mortgage payments on renewal, in order to repay their mortgage in full by 2037 as originally planned or 2) Maintain their existing mortgage payments on renewal and extend their mortgage amortization by several years.
After careful consideration, Brandon and Jeff decide to proceed with option 2. At this time, they simply don’t feel comfortable adding any additional expenses to their monthly budget as other expenses have increased as a result of inflation. They feel that this option allows them to continue current saving levels towards other goals while still working towards repaying their mortgage in a timeframe they feel is reasonable.
Variable mortgage, increasing interest costs
In contrast, rate changes will occur immediately with a variable-rate mortgage or other variable-rate loan, such as a line of credit. Those with variable-rate mortgages will realize an immediate benefit from decreasing interest rates and incur an immediate cost from rising interest rates. Although the mortgage payment amount under a variable-rate mortgage typically remains unchanged, an increase in interest rates will result in a greater portion of the loan payment being allocated to interest rather than principal repayment.
Case study: Jay and Krisha
Jay and Krisha became new homeowners in 2021 and opted for a variable-rate mortgage in order to benefit from the lowest rate at that time. They were aware that this low rate came at the cost of possible interest rate fluctuations in the future and felt they had some flexibility in their budget but did not anticipate the rapid increase to interest rates in 2022.
Based on the terms of their mortgage, Jay and Krisha are not required to increase their interest payments but have noticed that their mortgage payments are now primarily being allocated towards interest with only a very modest amount of principal repayment. They are concerned about this situation and don’t want to wait until 2026 to address this issue.
Jay and Krisha turn to several experts to understand the options available to them. With respect to their mortgage, two possible alternatives are identified: 1) locking their variable-rate mortgage into a fixed rate or 2) increasing the payments on their existing variable-rate mortgage. Recognizing that each of these alternatives requires additional cash, they complete a detailed review of their budget with their financial advisor. Together they identify two areas where Jay and Krisha are prepared to make some changes to their spending: 1) deferring the purchase of any new vehicles and 2) reducing their travel budget, for the time being.
As a result, Jay and Krisha decide that in addition to their regular mortgage payment, they will make an additional mortgage prepayment each month equal to 20% of the regular payment. They make prepayments rather than increasing the regular payments to provide for flexibility in case they are unable to fully achieve the planned budget cuts. They recognize that this will not fully address the impact of increasing interest rates and that the situation will need to be revisited. They plan to reconnect with their financial advisor in six months.
Homeowners feeling the impact of rising interest rates on their mortgage or other loans may assume those who are debt-free are immune from concerns around rising interest rates. This is not the case. Those hoping to enter the housing market may be concerned about rising interest rates and the future impact on home financing while debt-free homeowners may be concerned about the impact rising interest rates have had on their investment portfolios.
Case study: Nadia
Nadia has been retired for over 10 years and lives in a condo that she has paid for in full. She is entitled to Canada Pension Plan benefits, Old Age Security payments and a modest workplace pension. She also relies on withdrawals from her Registered Retirement Income Fund (RRIF) to fund a portion of her expenses in retirement. Nadia’s RRIF is invested in a conservative portfolio with both fixed-income and equity securities, with a heavier fixed-income weighting. Nadia’s recent investment returns are the worst they’ve been in the past decade, partly as a result of inflationary pressure fueling rising interest rates.
Understandably, the recent market volatility has been unsettling for Nadia who relies on her RRIF withdrawals. She discussed these concerns with her financial advisor. He reminded her that while her RRIF has declined in value in 2022 (both due to negative returns and as a result of RRIF withdrawals), this has not always been the case over the long term.
There have been a number of years since Nadia retired where her RRIF has increased in value due to returns exceeding her RRIF withdrawals. Her retirement plan is still on track and no shortfalls are anticipated in Nadia’s future retirement income. This conversation gives Nadia the comfort that she does not have to cut back her spending as a result of current losses in her investment portfolio.
Circling back to the FP Canada survey referenced at the beginning of the article, a large percentage of Canadians indicated that paying down debt (38%) and saving money (46%) would ease their financial stress. Making a concrete plan to address any concerns you may have in either area, with an expert who can help you see the whole picture, can be of great value to helping you achieve your long-term financial goals.
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