We are now three-quarters of the way through 2022. Congratulations! It has been quite an eventful year, with more still likely to come; war continues in Ukraine, US mid-terms are right around the corner, inflation is still way above targets, investment markets are down substantially, and interest rates have increased dramatically.
There is little that the average person can do in day-to-day life to influence global events or political decisions. It is also impossible to predict exactly what the future holds. When contemplating the future, it is best to think of possibilities rather than probabilities. What could potentially happen, not necessarily the likelihood of an event occurring.
When it comes to interest rates there are three possibilities; They could go up, stay where they are, or go down. Granted there are varying degrees they could go up or down. We cannot know for certain what will happen but it is best to look at forecasts and projections and be prepared.
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Background to Interest Rates
The main interest rate that dictates all other rates is called the bank rate. The bank rate is the interest rate at which a nation’s central bank lends money to domestic banks, affecting domestic banks’ monetary policy and loans.
The interest rate that consumers are more familiar with is called the prime rate. The prime rate is the interest rate that commercial banks charge their most creditworthy customers. Often you will see mortgage rates or loan rates advertised as Prime +/- ‘x’%. The prime rate is dependent on the bank rate. This means as the bank rate goes up, prime goes up, and by extension, the cost of borrowing for consumers goes up.
The act of controlling interest rates is part of monetary policy. Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.
Based on the definition of monetary policy, you can likely understand why central banks are currently raising rates. Interest rates have an inverse relationship with inflation. As interest rates go up, it should slow down economic growth, and thus, inflation should go down. The reverse is also true. If the central bank deems that the economy needs to grow more, it will lower interest rates, and thus, inflation should rise.
Although this is the general understanding of the relationship between interest rates and inflation, no one can truly point to what causes inflation. However, if we assume this relationship is accurate and that central banks will hold to it, what does that mean for interest rates going forward?
Where Are Interest Rates Headed?
The people in charge of the central bank in both Canada in the US have both been adamant that they will continue to raise rates until inflation is back to or near the target rate of 2%. The bank of Canada has two remaining meetings scheduled for 2022 on October 25 and December 6. Based on current sentiment we could likely see rate hikes at both of those meetings.
The current bank rate in Canada is 3.25%. That is up from 0.25% in March of 2022. Forecasts have interest rates rising to 4% by the end of 2022 and continuing slightly higher in 2023 to 4.25%. In tandem with those forecasts, inflation is expected to drop back down to 2% by the second half of 2023.
That seems quite optimistic considering how long it has taken other developed economies to get back to 2% inflation once they have reached levels seen in North America.
The big Canadian banks seem more optimistic when it comes to interest rates with TD and RBC thinking rates will peak at 4%. While CIBC, BMO, and Scotia think rates will peak at 3.75%.
For our previous thoughts on interest rates check out How High Will Interest Rates Go?
Consumers Taking a Hit
Consumers have already taken a hit in 2022, with higher costs of living and now higher costs of carrying debt. The hope is that the higher rates will help stabilize the increase in the cost of living. However, if rates keep climbing, consumers, specifically those with variable-rate debt like mortgages, will be hit even harder.
When it comes to variable rate mortgages there are generally two ways they can work. They can have a fixed payment, where if rates go up, the proportion going toward interest goes up but the payment remains the same. Or they can have variable payments, where when rates go up the total payment amount goes up to accommodate. Either way, when we started 2022 prime was sitting at 2.45%. It has now gone up a full 3% and is currently at 5.45%.
You might think, “Ah, 3% isn’t that bad.” However, in relative terms rates have gone up 122%. Yet many mortgage brokers are saying that rates are low, and historically when you compare them to the 80s and 90s, they aren’t wrong. However, people weren’t as leveraged then and the average price of a home relative to average household income was a lot more reasonable.
According to a recent Globe and Mail article, nearly three in every ten outstanding mortgages in Canada were variable rates at the end of 2021. In fact, 53% of home buyers opted for variable-rate mortgages in the second half of 2021. This was a departure from the norm that saw most people locking in 5-year fixed rates. Now those with variable rates are feeling the sting.
Variable Rate Example:
Let’s take the average mortgage in Canada as an example which is around $375,000. Let’s assume the rate on the mortgage is equal to prime, for simplicity’s sake. We will also assume a 25-year amortization period.
When prime was 2.45%, monthly payments would have been $1,670.55. Of that payment, $908.80 would have gone toward principal and $761.75 towards interest. Now there are two different possibilities, whether it is a fixed-payment variable rate mortgage or not.
If it is a fixed payment mortgage and rates go to 5.45%, we have hit what is called the trigger rate. The trigger rate is the point where the fixed payment is less than the interest that must be paid. In the case above, when interest rates go to 5.45%, the monthly interest payment is $1,684.10. That is $13.55 above what the monthly fixed payment is.
This only gets worse if we see rates go up more before the end of the year. Let’s take the forecasted 4% bank rate. If the bank rate goes to 4%, the prime will be 6.2%. In this case, monthly interest costs would be $1,912.94. That $242.39 is above what the fixed payment was scheduled to be. Having your mortgage hit the trigger rate is not good. It actually causes your mortgage to grow through negative amortization. This means the required amount above the payment amount gets capitalized onto the mortgage amount. Before that happens the lender will generally notify you.
Now let’s assume we don’t have a fixed-payment mortgage. The original payment when prime was 2.45% is still the same, $1,670.55. However, now that prime is 5.45%, payments would have increased to $2,278.07. Of which, $593.96 is going to the principal, and $1,684.10 is going to the interest.
If interest rates keep going up and prime reaches 6.2%, total payments will increase to $2,444.04. Of this, $531.10 goes toward the principal, and $1,912.94 goes toward interest.
For the past few decades, variable-rate mortgages have been a great option. However, we hadn’t had a period of rising interest rates. As interest rates hit their peak, variable-rate mortgages will become more attractive again. However, until that happens, many Canadians may be faced with the unfortunate reality of higher payments or their mortgages hitting their trigger rate.
Many people likely had no idea what a trigger rate is or how it could potentially affect them. Did your mortgage broker properly inform you of the risk of going with a variable-rate mortgage?
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