Stress test your debt
With interest rates at 50-year lows, many investors are wondering if interest rates are going to go up. For Canadians who hold debt, obviously they hope that interest rates stay low. For investors, especially conservative investors, they hope interest rates go back up to double digits so they can get better-guaranteed returns.
Interestingly, this paragraph was the first paragraph of an article I wrote for the Edmonton Journal back in 2004. As you can see, times have not changed much since then.
We are still sitting in a low-interest-rate environment. We are still talking about the possibility or likelihood that interest rates will rise. And we still have no clue what the future will hold!
What I find interesting about the interest rate debate is the speculation for rising interest rates has been going on for over 10 years now and every time someone says “rates have to go up” or “they can’t go lower” they seem to go lower.
Related article: Where are interest rates going?
Back in 2004 when I wrote the article, 5-year mortgage rates were about 4.9%. Today, with mortgage rates hovering around 3% and GIC rates even lower than that, it’s getting easier to argue that rates are likely to go up but the next question is “How much?”
Stress-test your debt
No one really knows if rates will rise or how much they will go up but rest assured that rising interest rates will impact anyone and everyone with a mortgage or other forms of debt.
If you want to prepare yourself for this possible outcome, it’s important to stress test your debt. Run some scenarios on your debt to see how higher interest rates will affect your payments, the time it takes to pay off debt and how much interest you will pay overall.
What if interest rates increased by 1%?
Let’s take a look at an example of stress testing your debt.
Jackson and Becca have a $250,000 mortgage, $12,000 owing on their Mastercard and $32,000 on their line of credit.
The mortgage is currently at 2.9% and will come up for renewal in 2 years. Their monthly payments are $1175 not including property taxes. To stress-test their mortgage, let’s take a look at some ‘what if’ scenarios to see what the impact of rising interest rates might be on their debt.
Scenario 1: Interest rates rise by 1%. In two years, they will have an outstanding balance of $235,000 on their mortgage at renewal. At 3.9% with the same remaining amortization, their monthly mortgage payment will go up to $1363.51 per month. That’s an increased monthly payment of $188.51 and the total cost of interest over the amortization period would increase from $75,535.45 to $108,603.61. That’s significant!
Scenario 2: Interest rates rise by 1.5%. At 4.4%, payments will rise $250 per month to $1425 per month.
Scenario 3: Interest rates rise by 2%. At 4.9%, payments will rise $313 per month to $1488 per month. Total interest paid over the amortization period would almost double to $140,103.11.
For interest sake, the last time 5-year mortgage rates were over 4.5% was May 2010. The last time 5-year mortgage rates were over 5% was January 2009.
My five cents
So what’s the point? I’m not here to try and predict where interest rates are going or how much they will increase in 2 years. The truth is I have no clue but the possibility of mortgage rates being 4%, 5% or more is real. The point I am trying to make is if interest rates rise, will you be in a position to be able to handle higher payments and what is the longer-term impact on your total interest costs.
Financial planning is about looking into the future to make the future more predictable. Jackson and Rebecca felt they could handle increased mortgage payments of $200 to $250 per month but what about the credit cards and the line of credit. When it comes to stress testing your debt, you have to stress test all forms of debt.
And here’s one final thought for Jackson and Rebecca. If they can afford an extra $200 per month increase, why wouldn’t they put that against the mortgage now? Increasing payments in a low-interest-rate environment mean you can pay the debt off faster and they will have more flexibility and options if interest rates do rise in the future.