To reign out-of-control inflation, The Bank of Canada (BOC) has recently engaged in an aggressive campaign of rate hikes. On June 1, 2022, it raised the target for the overnight rate to 1.5%, its third consecutive rate hike – and signalled to the market that further increases are to follow.
There’s no way to predict how high and quickly the BoC will raise rates to tame inflation (the highest since the early 1980s). But what’s certain is that borrowers across the country will feel the effects in their pockets. In particular, those responsible for a mortgage need to heed the BOC’s warnings about their future payment obligations.
Depending on their mortgage situation, they may realize a steep increase in their monthly payments, putting their household budgets under stress. Others may not feel any negative impact, at least for several years. And first-time homebuyers will face more challenges securing mortgage financing.
In this article, we explore how the current environment of rapidly increasing interest rates will impact mortgages. And what you can do to prepare.Let’s Talk
What happens to the mortgage market when interest rates rise?
Interest is the cost of borrowing money. So, when interest rates across the economy start to climb, borrowing money becomes more expensive. This concept applies to personal loans, lines of credit, student loans, mortgages, etc.
As secured loans, mortgages naturally offer among the lowest interest rates of any debt. Thus, on the surface, an increase from 3% to 3.5% may seem negligible.
However, mortgages are hefty loans requiring decades to pay in full. A seemingly minor rate increase of 0.5% on a $500,000 mortgage will add up quickly over time. The result is thousands of dollars in extra interest over your mortgage’s lifespan.
A spike in interest rates makes it much more expensive to refinance your mortgage to tap into your home equity. Rising rates depress home prices, as demand for housing declines when financing them becomes more costly. As your home equity plummets, you’ll have access to less cash. Qualifying for a home equity line of credit (HELOC) also becomes more challenging.
Also, when you attempt to refinance, you’ll have to pass the mortgage stress test again. Naturally, with rates heading up, you’d have to requalify for your new mortgage at a higher rate, which may prove unfeasible.
How rising interest rates affect different types of mortgages
When it comes to mortgage rates, there are three types you can choose: fixed-rate, variable-rate, and adjustable-rate.
Depending on your choices, surging interest rates will impact your mortgage costs differently.
If you opt for a fixed-rate mortgage, the interest rate you pay will remain the same throughout your mortgage term. Fixed-rate mortgages are suitable for risk-averse homeowners who value stable and predictable payments.
By choosing a fixed rate, you’re shielded from interest rate hikes anywhere from six months to ten years, depending on your mortgage term’s length. This feature is a fixed-rate mortgage’s key selling point.
The major downside of a fixed-rate mortgage is that the rates are typically higher than those with floating rates (variable and adjustable-rate mortgages), resulting in larger payments.
Furthermore, let’s say your mortgage is up for renewal amid a high-interest rate environment. In that case, you’ll have no choice but to pay the current market rate, meaning you’ll get saddled with a higher monthly payment. The extra cost can severely dent your bank account if you earn a low income.
The prime rate is the rate lending institutions charge to their most creditworthy clients. It generally moves in tandem with the overnight rate. Variable-rate mortgages are, therefore, heavily influenced by the actions of the BOC, even more so than fixed-rate mortgages.
As interest rates rise, your variable-rate mortgage payments will stay consistent, much like a fixed-rate mortgage. However, your lender will allocate a more significant percentage of each payment to the interest component rather than the principal. As a result, you’ll incur more interest charges over the life of your mortgage, and it will take longer to pay it off.
Variable-rate mortgages typically offer lower rates than those with fixed rates.
With an adjustable-rate mortgage, your interest rate may change periodically based on movements in your lender’s prime rate, much like a variable-rate mortgage. However, a shift in the prime rate will alter the size of your payments.
Each time the BOC hikes the target for the overnight rates, you can expect a corresponding increase in your mortgage payment. Should rates climb too high too quickly, your household may struggle to cover other debts like credit cards and day-to-day expenses.
An open mortgage allows you to make additional payments toward your principal during your term. You can even pay off your entire principal if you wish, all without incurring a prepayment penalty. This type of mortgage is available for terms that range from six months to five years.
Open mortgages are suitable for homeowners who value the flexibility to pay off their mortgage balance sooner. However, this privilege presents additional risk to the lender, who would lose out on considerable interest revenue should the borrower pay off the loan early. As a result, lenders charge higher rates on open mortgages to compensate for the added risk.
Due to their steep interest rates, open mortgages are relatively rare in Canada. They become particularly unaffordable if rates rise sharply.
With a closed mortgage, you cannot contribute additional payments toward your balance throughout your term. You must adhere to your regular payment schedule. This type of mortgage is available for terms from six months to ten years. It’s ideal for those who don’t plan on paying off their balance early.
Most lenders allow you to make additional payments toward your outstanding balance each year, but up to a limit. Depending on your lender’s terms, you may be able to increase your regular payment or pay a lump sum amount.
Because closed mortgage doesn’t provide much flexibility for homeowners to pay off their loan early, they come with lower rates than open mortgages. Not surprisingly, they’re by far the cheaper option when general rates rise. [m2]
How to manage your mortgage when interest rates are on the rise
When interest rates start creeping up, you must put extra thought and planning into your mortgage. Here are some tips:
- Make a large down payment. If you’re a first-time homebuyer, contributing a sizeable down payment allows you to apply for a smaller mortgage.
- Choose a fixed-rate mortgage. If you value security and stability, choose a fixed-rate mortgage with a long term. You’ll pay a higher monthly payment but will have protection from future rate hikes. You can always refinance your mortgage at a lower rate if market rates drop a few years into your term.
- Lock in a rate as soon as possible. Most financial institutions allow you to lock in your rate several months before your term expires. Take advantage of any early renewal feature in your mortgage contract when rates begin to spike.
- Extend your mortgage amortization period. If your new mortgage payments are too demanding, consider extending your amortization period. Doing so will allow you to spread your remaining principal over a longer period, resulting in smaller monthly payments.
- Pay down or consolidate high-interest debt. Reducing your high-interest debt will free up more cash to service your mortgage payments and daily expenses.
- Convert to a fixed-rate mortgage. Consider converting your variable-rate mortgage into a fixed rate.
- Choose a closed mortgage. Closed mortgages offer lower rates than open mortgages and are available with terms up to ten years (compared to five years for an open mortgage).[m3]
What if you’re experiencing financial difficulty? Can you discharge your mortgage under bankruptcy?
An economy marked by high-interest rates places a heavy burden on those with a tight budget and significant debt like a mortgage.
If you feel there’s no way you can maintain your debt obligations, bankruptcy may be the best option to pursue to eliminate it. It’s an extreme choice, for sure. But the relief and empowerment of freeing yourself from burdensome debt are worth it. And you can gradually rebuild your finances over time.
Remember that you cannot discharge a mortgage in Canada if you file for bankruptcy. Typically, you can only discharge unsecured debt, like payday loans, credit cards, and past-due bills. Secured loans like mortgages can be discharged only if you give up possession of your home to your lender. If you wish to keep the property, you’re expected to continue making your mortgage payments.[m4]
Still, freeing yourself of unsecured debt can leave you with enough excess cash to maintain your mortgage payments. If your mortgage payments are in arrears for too long, your lender can legally take possession of your home and sell it to cover the mortgage. Not a pleasant scenario!
Alternatively, you may consider filing a consumer proposal, which is a much less severe option than bankruptcy. Under this scenario, you can negotiate a reduced payment plan with your creditors. While you can take steps to keep your home when filing for bankruptcy, a consumer proposal is a superior way to safeguard it from creditors.
Your personal residence will likely be the most significant asset you acquire during your lifetime – and your mortgage the most expensive liability you undertake. Don’t let soaring interest rates endanger your home. If you’re struggling with debt, book a call today with a Licensed Insolvency Trustee to discuss your options and get your finances back on track.
A Licensed Insolvency Trustee is the only professional with the expertise and authority to carry out a government-regulated debt relief program on your behalf, such as a consumer proposal or bankruptcy. They can help you legally discharge or reduce your debt, allowing you to rebuild your financial house from the ground up.
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