#### 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*