The Low Interest Rate Fallacy: Why You Should Stress Test Your Debt

by True Wealth Advisors


How low can interest rates go? Even lower, apparently. Last week the Bank of Canada cut the overnight lending rate 25 basis points to 0.5 percent from 0.75 percent. This is the second time our central bank has trimmed interest rates in 2015. While the rate cut in January caught the general public off guard, it was expected by many in the financial world. 2015 has been quite a turbulent year. With interest rates previously stuck at 1 percent for nearly five years and the toll taken on our economy by the hammered price of oil, the growth prospects for the country seemed fairly dim.

While many would categorize this as just the normal ‘market cycles’, you’re probably wondering how this affects the average person. A weak Canadian economy means low interest rates are here to stay for the foreseeable future. However, before you start using your home as an ATM, there are some important things to consider.

What Interest Rates Mean to Families

You may be wondering why interest rate announcements get so much media attention and market reaction. Interest rates affect our lives in more ways than you think. Banks set prime rate based on the overnight lending rate. When the Bank of Canada changes the overnight lending rate, the banks are sure to follow. For example, when the Bank of Canada lowered the overnight lending rate to 0.5 percent last week, most of the big banks lowered prime rate to 2.70 or 2.75 percent. Anyone with debt tied to prime benefits. Examples include variable rate mortgages, home equity line of credit, car loan, line of credit and student loan. A lower prime rate means more of your money goes towards principal and less towards interest (hooray!).

Although the interest rate cut is meant to stimulate the economy, the biggest worry of the Bank of Canada is that Canadians will get further into debt. With the household debt-to-income ratio near a record of 163.3 percent, Canadians are piling on debt like never before. But as the saying goes, all good things come to an end. Interest rates may be low now, but they won’t be this low forever.

Stress Test Your Debt

Despite how much planning you do, sometimes life happens. Illness, job loss and divorce are things we rarely plan for when taking on debt, such as a mortgage. That’s why it’s important to prepare for the worst. When you stress test debt, such as your mortgage, you plan for a worst case scenario. A stress test helps you figure out if you’d be able to survive in case rates (and we all know it’s inevitable) or your payment were to increase, or if you would be caught in a panic. A good rule of thumb is to use a scenario of rates increasing by two to three percent (we’re going to be aggressive and use three percent in our example).

Let’s say you have a $400,000 5-year variable rate mortgage with a 25 year amortization at 1.99 percent. Your mortgage payments are currently $1,692 per month. But 1.99 percent is such a low rate. What if your mortgage rate were to go up by three percent? At 4.99 percent, your mortgage payments would take a big jump to $2,324 per month. That’s $632 higher, folks (or an increase of over 37%) – yikes! Although the likelihood of interest rates jumping by so much in such a short period of time isn’t great, this example just goes to show you the affect it can have on your cash flow.

I’m not saying you shouldn’t buy a home, because a home can be a good long-term investment – but what I am saying is that you should plan for a rainy day. When it rains, it usually pours. The low interest rate environment won’t last forever, so it’s important and prudent to plan for when rates rise, so you aren’t caught off guard. The low interest rate environment also presents other challenges, like the effects it can have on your savings. We will discuss this in detail in a subsequent article next week. In the meantime, if you’re thinking of taking on additional debt or need to stress test your current debt levels to ensure you’re prepared for unforeseen circumstances, feel free to contact our office and let us help you fully weigh your options.

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