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Should You Stress Test Your Debt?

Break Out Of Debt

I just finished reading the latest report from Statistics Canada that Canadians are carrying more debt than ever, with the average household debt to income ratio surging past 164%. For people hoping that further interest rate drops by the Bank of Canada will enhance their buying power with lower lender rates, they are going to be disappointed.

That’s because the biggest portion of most people’s debt relates to their home mortgage, and mortgage rates won’t fall to the levels associated with cuts to the prime rate. Adding to the debt dilemma, home prices in many markets are at record highs. So it’s important to stay away from risky borrowing practices.

Most lenders dictate that total debt-to-income ratio (including loan and credit card payments, and child or spousal support) shouldn’t be more than 36% of annual income. So for someone earning $200,000, their totals annual before-tax total debt payments should not be in excess of $72,000, or $6,000 per month. Additionally, mortgage payments including principal, interest, taxes and insurance should not exceed 28% of gross income.

People who have large mortgages might be shocked as to what could happen to their payments if interest rates rose. For example, payments on a five year variable-rate mortgage at 3% on a $400,000 loan, with a 25-year amortization would be $1,893 monthly. This breaks down to $11,776 of interest and $10,940 going toward principal each year. If the mortgage interest rate was to increase by half a percent, monthly payments would increase to $1,997 and the annual interest cost would rise by $1,959. Worse yet, there would be $710 less going towards paying down loan principal.

While the increase in annual mortgage payments may not seem high, it can add up, especially if rates rise further or the loan is on a million-dollar property. To be safe, people need to build in a buffer to protect themselves for possible rate increases. Here are some suggestions to help you prepare for the possibility of the risk of increasing interest rates in the future:

  • Ensure you can afford possible increases to your current mortgage payments by running a stress test at various rate increases, for example: 1/2%, 1%, and 1.5%.
  • If you own any fixed income investments, it also means more rate exposure. So if you’re looking for yield, consider buying alternatives like floating-rate bonds.
  • Also consider avoiding locking in to long term bonds until after rates have topped out. If you already hold long-term bonds, consider selling.
  • For any equity investments that you’re currently considering, look for companies that have strong management teams and proven long-term track records.

Rising interest rate risk aren’t all one needs to worry about. Future employment or related situational risk, such as job security need to be considered. Does your career offer growth opportunities? Are you protected if you become disabled due to sickness or injury? A perfect storm could occur if interest rates were to spike, you were laid off, had little short-term cash reserves, and your equity portfolio value imploded!

Take the time to sit down with an experienced financial advisor to help you prepare for unseen risk or unanticipated events that could derail your financial and life goals.

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