Would Increasing Interest Rates Leave You Struggling with Payments?

Would Increasing Interest Rates Leave You Struggling with Payments?

interest rates

A credit rating company recently reported that almost a million Canadians, including some who currently have excellent credit ratings, could have significant problems paying their monthly debts should interest rates rise by 1%.

Credit scores measure past financials, not the impact of future stress caused by cutbacks or job losses, so even those who have excellent credit ratings could experience difficulty meeting their monthly obligations.

We know lenders invariably tighten their loan qualification requirements during economic downturns. This is the kind of review they will be doing already with sub-prime consumers, it’s the “super-prime” rated ones that might catch them off guard.

Current estimates show approximately seven million Canadian consumers have a variable-rate mortgage or a line of credit with a variable interest rate. About 700,000 of these could struggle with increasing monthly payments related to a quarter-point rate hike, and over a million if there were a one percentage point increase.

For example, on a $300,000 mortgage, an interest rate increase of a quarter-point would add $37 more to your monthly payment, and 1% increase would increase it by $150.

Conversely for variable rate mortgages, the payments could depend on the lender’s guidelines. With some lenders payments could remain the same, but with more allocated to interest payment and less going to principal reduction. Others would increase the monthly payments as interest rates rise.

But the increase in monthly payments is only one part of the equation because some may be able to cope with the increase by cutting back on extras. Others may not be able to absorb the extra costs in order to put gas in their tank to go to work, or to put food on the table!

Adding to the problem, Canadian consumers have piled on record amounts of debt in recent years with interest rates remaining near record lows, encouraging rash spending.

On top of this is the Bank of Canada’s overnight interest rate target set at 0.5% since it was cut twice last year. This rate is a key variable for the big banks when setting their prime rates and the rates for borrowing for variable rate mortgages and lines of credit. Economists aren’t expecting the central bank to raise its key interest rate target at any time soon, as it’s expected to maintain this at well below what would be considered a normal level. Consumers and financial institutions will be watching Statistics Canada’s next assessment on household debt with great interest to see which way if might trend.

It begs the question, if there’s an interest rate increase, will you able to meet your monthly financial commitments on a timely basis?

My recommendation going forward for households is to watch all of their discretionary spending. Build a rainy day fund sufficient to cover three months household expenses. Track all spending to understand where their money is going, then develop a budget so they have control. Budgeting is not about spending all that you earn every month, or running out of money before month end, but rather a monitored process to keep control.
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