Interest Rates and Consumer Debt

As always, the economists cannot agree on where interest rates are going. Actually, they never seem to have consensus on where anything is going. I was asked last week if someone should lock in to a new 5 year mortgage term, or just keep playing the variable rate game. An hour or so later I was able to help this couple understand all the criteria they needed to consider in order to make a good mortgage decision for their family. There were 3 different things to consider in their criteria:

What to consider when locking in mortgage debt

1. The financial facts of their situation. Including: Did they have other debt? How secure was their income? How much cash flow did they have? What discretionary expenses and savings level did they have in their budget?
2. Their risk tolerance (this part of the discussion took the longest because while it sounds instinctive; it is complex and involves two humans who are guaranteed to need to compromise to make this work). Some example questions they needed to ask themselves: (a) if “A” lost his/her job at what point would they think they needed to sell the house? Was it when their savings ran out? After a fixed period of time unemployed? (b) if interest rates went up significantly what would they have to cut first?
3. What were their financial priorities (based on reasonable assumptions) for paying off their mortgage, providing for the post-secondary education of their kids and saving for retirement.

“But will interest rates go up or down?” they asked. My crystal ball is about as opaque as the next person’s. We just have opinions and can try and support them – kind of like the professional economists who disagree. But when I gave them my answer, they were still frustrated (more on that later). Interest rates will go up – I just don’t know when. “Fat lot of help that is!” So I brought their minds back away from the speculation on interest rates, to focus on the project explained in steps 1 through 3 above.

Interest rate risk vs. reward

Somewhat reluctantly, they left to do their homework. A few days later, they returned. To their credit, they had done a very thorough job figuring out their financial facts, priorities, and risk tolerance. Their frustration had disappeared, because now they were looking at the mortgage renewal situation strategically and objectively. Their decision reflected the quality of their homework. They would stay on variable rates, as they could comfortably sustain a 1% rise in mortgage rates, but would lock into a longer term as soon as rates increased by at least 0.75%. Why is this important? Their mortgage in the Greater Toronto Area is $700,000. 1% p.a. equals a further $7,000 p.a. to pay in interest in after tax dollars. Were they right? I’ll know in a few years time if they won the interest rate bet. But they are now very informed, and not risking losing their home or having to rely on credit card debt to survive if they hit a bump in the road. If interest rates go up it will have an enormous impact on regular people’s ability to stay afloat, and avoid losing their houses unless they prepare for it properly.

How to choose your interest rate

Here’s how to prepare:

1. Do a stress test on your budget of what your mortgage payments will be if interest rates go up 1% through 5% (don’t laugh, I remember paying 13.25% on a first mortgage in 1990).
2. Shed high interest debt (credit cards, store cards and shhhh… the hidden shame pay day loans) now. Consider a consumer proposal or debt management program to achieve this.
3. Don’t be afraid to ask a professional for help. We are not born financial whizz kids, and our parents didn’t teach many of us anything useful in this regard either. If it is debt, only trust a licensed insolvency trustee to help you avoid bankruptcy now and in the future.

Are you unsure about your debt? Are you afraid that a rising mortgage interest will exhaust your financial ability? Do you have trouble paying your bills, credit cards, or loans? The contact us for a free, non-obligation consultation to review your debt and all opportunities to relieve financial stress.