Tuesday, April 24, 2012

Now is the time to get ready for an interest-rate increase


Preet Banerjee

Now is the time to get ready for an interest-rate increase

From Wednesday's Globe and Mail
Published Tuesday, Apr. 24, 2012 6:00AM EDT
The future is unknowable, but it doesn’t stop people from guessing about it.
And when it comes to interest rates, this seems especially true. Haven’t you heard? Interest rates will probably be going up, making debt payments unaffordable for some Canadians, who will lose their homes, causing a popping of the housing bubble, which could result in a recession.
Well, that’s one prediction.
But remember in Back To The Future Part II, when “future Biff” travelled back in time and gave “past Biff” a sports almanac so he could make lots of money by betting on sure things? Anyone who actually knew the future wouldn’t share that information when they could profit handsomely by keeping it to themselves.
And while hindsight is 20/20, we don’t have the luxury of going back in time to do anything about it, like Biff. For those of us anchored in one continuous timeline, Warren Buffett reminds that “if past history was all there was to the game, the richest people would be librarians.”
Even though the Bank of Canada has not set anything in stone, it’s wise to consider a future with increased interest rates. A hike means mortgage rates, lines of credit and other forms of borrowing money will get more expensive. That will deter some people from borrowing, and might cripple some segments of the population that have already borrowed too much. Debt that is affordable at today’s rates may be unsustainable at tomorrow’s.
For example, some variable rate mortgages are set up so that payment amounts increase when interest rates go up. This can mean that your cash flow takes a surprise hit.
But before you start worrying about where you will make the corresponding cut in your current spending to offset this increase, it’s worth noting that not all variable rate mortgages will automatically increase your payments if rates rise.
Robert McLister, Editor of CanadianMortgageTrends.com, notes that some variable rate mortgages are set up with a variable rate but fixed payment (true variable rate mortgages, or VRMs) and others are set up with variable rates as well as variable payments (adjustable rate mortgages, or ARMs). Both are called variable rate mortgages in common practice, Mr. McLister says.
As rates rise, an ARM will see your payments increase, but a true VRM will see your payment stay the same with the caveat that less of your payment goes towards paying down principal and more goes to paying interest. In other words, the amortization or your mortgage would increase, not the payment.
Based on the current forecast, Mr. McLister notes that “if someone is shopping for a brand-new mortgage and won’t need to break it for five years, then five-year fixed rates have the mathematical edge.” If you’re conservative and willing to pay more in the first five years, he adds, a well-priced 10-year term is also worth a look.
The Bank of Canada is being fairly clear: The economy is getting better so low rates, an incentive to borrow and spend money, could rise soon. It was conditional enough to still be a warning shot, but one close enough to make you want to duck.
If you have significant debts, now is the time to try to get them under control. Overspenders have been living on borrowed time, let alone money, for years. Rising rates may not cause a housing correction or a recession, but here’s a prediction you can bank on: The increase in interest payments for some Canadians will make rising gas prices seem trivial.
Snapshot of a rate hike
If interest rates rose by two percentage points*:
- The payment on an adjustable-rate mortgage of $200,000 with a 25-year amortization with an initial rate of 3% could increase from $946 to $1,144 a month. That’s an increase of $198.
- Financing $30,000 for five years at 6.5% would be $587.09 a month. At 8.5%, it would be $615.64 a month. That’s an increase of $28.55.
- $10,000 in a high-interest savings account paying 1.35%** would earn $135.84 in one year. If it paid 3.35%**, it would earn $340.19 in one year. That’s an increase of $204.35.
*Note that while it is unlikely for rates to rise by two percentage points in a short time frame, it is quite possible over a few years.
**Assumes monthly compounding.
Preet Banerjee, B.Sc, FMA, DMS, FCSI, is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com. You can also follow him on twitter at @PreetBanerjee

Monday, April 16, 2012