One of the major themes of the articles written since this blog started in November 2016 has been the potential for a major shift in the trend of interest rates. Since July 2017, the Bank of Canada has raised the overnight rate three times to 1.25%. These increases have raised the interest costs on Variable mortgages and HELOCs (Home Equity Lines of Credit) and have influenced and increased the interest rates of Fixed mortgages. It certainly seems to be time for home owners with mortgages to stress test their levels of debt to protect against the potential for much higher interest rates. The trend in rates has changed and now it is only a matter of how quickly it accelerates.
The Canadian mortgage market differs from the U.S. market in a number of ways including the inability for Canadians to deduct interest payments. Another attribute of the U.S. market that is not available in Canada is the ability to match the term of a mortgage to the amortization. In the U.S., buyers of homes can match a home purchase with a 30-Year Fixed mortgage that locks in the rate and provides long term clarity and certainty. In Canada, this mortgage product is not available and 5-Year Fixed mortgages are overwhelmingly popular. The shorter 5-Year term provides a high level of uncertainty and risk for Canadians every time their mortgage renews as rates may move substantially between terms. If regulators and financial institutions really want to lower the overall risk to Canadian home owners they might want to introduce a 15-30 Year term mortgage options to allow borrowers to lock in at low rates. As things stand currently, home owners with higher leverage need to protect themselves.
Fixed or Variable Rate Mortgage?
There are two (2) sides to the mortgage decision, one financial and one emotional.
Until recently, it has made financial sense to consider a 5-year Variable mortgage as this rate has been lower than 5-Year Fixed rate and the potential for the Bank of Canada to raise interest rates was low.
Even during the very low interest rate environment, many home owners have preferred the predictability of a Fixed mortgage rate where the interest costs remain the same during the term of the mortgage even if the interest cost was higher than the Variable mortgage.
With the Bank of Canada raising interest rates 0.75 bps in the past 10 months, even the financial part of the mortgage decision is more nuanced than it has been in the past. Every home owner’s situation will be different and the most important thing may be to stress test to higher interest rates as the regulators have started doing with new home buyers.
How to Stress Test?
It is relatively easy to calculate the annual interest rates on a mortgage and the risks of higher interest rates. Just take the outstanding principal on the mortgage and multiply it by the Interest Rate (this is meant as a quick calculation and does not take into account effect of the reduction of principal over the term of the mortgage).
$300,000.00 Principal at 3.50% Rate = $10,500.00 Annual Interest Cost
To calculate the effect of higher interest rates, just change the rate to have an idea of future interest costs at different potential rates.
(i.e. if rates move from 3.50% to 5.50%, the annual interest costs on the same $300,000.00 mortgage would be $6,000.00 higher = $16,500.00. If rates move to 8.00% than the costs would be $13,500.00 higher = $24,000.00)
It is very evident from this example the structural risk of the current real estate market especially as many mortgages would be much larger than the example. It is a simple exercise but many Canadians probably do not consider the actual annual interest costs that they are paying.
Mortgage vs Income
The historical guideline used to be that one should consider taking out a mortgage that was no more than 3x household income. For reference, there are cities in Canada where housing prices are now over 20x household income. The exceptionally low interest rates have made these homes “affordable” but higher rates are already causing challenges.
Canadians looking at their mortgage renewal options might look at the amount remaining on the Principal relative to their household income. The higher the multiple to income the more important it may be to choose a mortgage option that protects against higher interest rates for the longest term that is financially affordable. If the multiple to income is reasonable (below 3x) then one might not be overly concerned. There is still flexibility to still choose the lowest rate available. If one has higher mortgage debt then one might even explore a 7 or 10-Year mortgage. The interest costs will be higher but the rates are historically very low and this may protect against very negative outcomes over the longer term. A longer-term mortgage will increase clarity and could be accompanied by prepayments to lower the additional interest cost over the term.
It is evident that even the small rise in interest rates has already started to reveal problems for Canadians with high debt levels. This confirms the realities of what may lay ahead for the real estate markets and the Canadian economy as high prices for real estate have been accompanied by high levels of mortgage debt.
One major potential reality that seems to be ignored by financial market participants is that the reason for much higher interest rates in the future will probably have nothing to do with the willingness of Central Banks to raise short term rates. Recently there does seem to be a greater appreciation of the high levels of global sovereign debt. It is this massive debt that increases the risks of the sovereign bond market driving yields much higher. If global market participants demand a higher return from seemingly insolvent governments (of all levels) then bonds will move much lower and the rates of Fixed mortgages will head correspondingly higher and Variable rates will follow. This happened in the 1970s and the risks in this cycle may be much higher.
This publication is solely the work of Jon Batchelor for the private information of his clients. Although the author is a Manulife Securities Advisor, he is not a financial analyst at Manulife Securities Incorporated and Manulife Securities Insurance Inc. This is not an official publication of Manulife Securities. The views, opinions and recommendations are those of the author alone and they may not necessarily be those of Manulife Securities. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Securities or any other person as to its accuracy, completeness or correctness.