As the years roll by, the interest rates for almost any kind of credit product are bound to rise and fall periodically. After all, lenders are businesses like any other, and just like any business, their services need to evolve with the rest of the world in order to make a profit. Remember when gasoline used to cost under $0.90 a litre? Today, seeing a litre of gas goes for over $1.20 is nothing new. Well, the same principle must be applied to interest rates. As much as we hate to admit it, most things are going to have to change at some point.
Unfortunately, there’s not much that borrowers can do about these rising interest rates, except save up and get ready for the next spike, which hopefully won’t be for a long while. Then again, saving money is easier said than done when you’re already dedicating the majority of your income to other avenues, as is the case with most Canadian homeowners. However, if you are a borrower and you’re a bit worried about the changing of the tides for your interest rates, there are a few things you can do so that they don’t catch you off guard.
The Cost of Borrowing in Canada
Financial experts are speculating that the recent rise in interest rates are an incentive, put in place by the Canadian Government as a way to deter potential borrowers from overspending on their credit products, particularly when it comes to the housing market. While the Government obviously isn’t trying to stop its citizens from buying homes, they are trying to persuade them to buy ones that within a more reasonable price range.
Unfortunately, the affordable housing crisis has become a problem in Canada over recent years, especially in our more expensive cities, such as Vancouver and Toronto. Essentially, would-be homeowners are trying to purchase homes that they won’t actually be able to afford a few years into their amortization period. Many of those borrowers, drawn in by the prospect of becoming homeowners, don’t look past the initial price tag on their house at the interest rates that come with their mortgage payments. When all their financial resources are going into maintaining their household, even a few hundred dollars extra each year can end up draining their finances severely. Being that the Canadian real estate market makes up a significant portion of our country’s economy, this spike in interest rates is an attempt at improving the financial stability of the areas in and around our less affordable cities. The only problem is that many borrowers either don’t shop around to find a lender that offers more reasonable rates or don’t bother trying to negotiate for a better one.
For a better understanding of the cost of borrowing in Canada, check out this infographic.
How Do Interest Rates Work?
Essentially, interest rates pertain to the cost of lending. When a consumer asks to borrow money for whatever they might need, they’ll be charged a certain percentage for the use of that money, the amount of which corresponds to how much they’re borrowing. The more interest the lender charges, the more profitable the product is for them. Generally speaking, banks and other financial institutions set the bar for most interest rates on various types of loans.
How Interest Rates Are Calculated
The interest rate that you’ll be charged on whatever credit product you might be applying for is based on two factors. The first is known as the “market premium”, wherein the interest rate will be calculated based on the position of the market at that time. In other words, the basic cost of lending for whatever credit product you’re interested in. The second factor is known as the “risk premium”, which is based on your own financial standing at the time when you either apply for or renew your credit product. This premium is the percentage that covers the lender’s investment should you not be able to pay back the full balance of your loan and, for the most part, is calculated in accordance with your current credit score. The higher your credit score, the better interest rate you’re likely to be approved for and vice versa. Once both premiums are determined, they’ll be combined to form a “fixed” or “variable” interest rate, both of which we’ll explain in the following section.
This type of interest rate is known as “fixed” because it does not change until the loan term is over. The rate is dictated in advance, in the loan agreement, and should not rise or fall until the appropriate time has passed and the offer has expired. If the loan term ends, but the borrower needs to extend it into another (if the loan isn’t paid in full by that point), the lender will either offer them the same rate or a new one. In most cases, a slight rise in rate will be the likely outcome.
A fixed rate is usually a more desirable offer, simply because it gives the borrower a better understanding of how much they’ll actually be paying over the course of their loan. They’ll have the initial loan price but will also have to factor in the cost of interest, which will be easier to do once their rate has been locked in. So, not only will the borrower be able to get a more exact calculation of what they’ll be spending, but a fixed rate can also give them the appropriate time to prepare their finances for it.
Variable (Floating) Rate
The second type of interest rate is known as “variable” or “floating” because it fluctuates as you make your regular payments throughout your loan term. Once again, the first portion of how your rate is calculated based on the market premium at the time your loan is approved. Your own risk premium will also be negotiated based on your financial history and standing. However, where a variable rate differs from a fixed rate is that it’s going to shift along with the current market. So, if the market takes a dip, you could see your interest rate getting lower. In turn, if the market rises, so too will your rate.
With a variable rate, you would also be sharing a percentage of the risk with your lender, which is appealing because it could mean that your lender will offer you a lower rate (lower than a typical fixed rate) for the first part of your loan term. Since Canadian interest rates don’t tend to fluctuate too much from year to year, variable rates work well for short-term loans in particular. If you have a variable rate and manage to pay off the full amount of your loan, you might be able to save some money on the back end.
For more information about interest rates, read this.
How Your Interest Rate Rising Can Affect Your Finances
While both fixed and variable interest rates come with their benefits and drawbacks, one thing is certain. The higher your interest rate is, the more expensive your loan payments will be overall. So, once interest rates rise, your regular payments will increase if you currently have a variable rate on your mortgage, lines of credit or other loans. The same will happen if you have a fixed-rate, but your loan term is over and needs to be renewed.
What’s the difference between a mortgage term and a mortgage amortization? Find out here.
One thing that a lot of borrowers fail to realize before they sign up for various credit products is that certain lenders will offer a lower interest rate at the beginning as a sales tactic, often during a promotional period. Those same borrowers then end up taking that one-time rate for granted. Afterward, if they have a variable rate or their loan term is needs to be renewed, their interest rate could and probably will rise. Even if that rise is only by a fraction of a percentage, it could cost them a lot of money in the long run.
You can visit the Government of Canada website for some examples of how your credit products and finances will be affected by a rise in interest rates.
Steps to Prepare Your Finances a Rise of Interest Rates
As we mentioned previously, many borrowers run into debt problems because they aren’t considering the long-term effects of their interest payments. This can be said about any type of credit product, especially the ones with very high-interest rates, such as typical credit cards, which can be as much as 19.99%. For that reason, it’s very important that you take the proper measures to protect your financial future from those rises in interest rates, few and far between as they may be.
Here are just a few of the steps you can take:
- Start a budget. Cut down on your household and living costs, eliminating any unnecessary consumer expenses.
- Using the money you’re saving, pay down your debts, starting with the largest ones or those with the highest interest rates.
- Whatever money you don’t spend paying down debt, deposit into an emergency savings fund for both the heightened interest rate payments and any other unexpected expenses.
- Stay away from mortgages or lines of credit that you won’t be able to afford in the long run. The more credit you use up, the more time and money you’ll spend trying to pay it off.
- Always make your payments on time and in full to avoid any penalty fees or extra interest.
- If necessary, go to your bank and apply for a debt consolidation loan. If approved, you’ll be given one larger installment loan in order to pay some of your smaller debts.
Interested in knowing how much it will cost you to purchase a house in your city? Click here.
Think About How Your Interest Rate Will Affect Your Future
When it comes to dealing with the potential debt caused by the recent rise in interest rates across Canada, one of the most important things you can do is think about your future financial goals before things get too out of hand. While a little bit of extra interest money every month might not seem like much, it can add up quickly and you might not realize how profound of an effect it’s having on your finances until it’s too late. So, always make sure to take that into account before applying for a credit product of any kind. Depending on your current financial situation, your new rate might not be a problem yet, but it could be very quickly if not managed properly.
Want to know why different lenders offer different mortgage rates? Check this out.
If you’re unsure about how a higher interest rate might affect your finances, speak to a financial expert before you sign up for a new credit product or renew an existing one. They’ll be able to calculate both your loan payments and your APR (annual percentage rate), which is legally required to be displayed within any loan agreement in Canada. This way, you’ll have a better understanding of how your finances will look in the future, after a hike in interest rates. Remember, your financial future should be a top priority. Since pesky interest rates can sometimes get in the way of that goal, it’s best not to take them lightly.
OSFI Sets Stronger Rules For Mortgage Qualification in Canada
Speaking of deciding if you’ll be able to afford a higher interest rate, the Office of the Superintendent of Financial Institutions (OSFI) announced on Tuesday that they’ll be setting even stricter regulations for all Canadians looking to purchase a house in 2018, in the form of a stress test for all borrowers.
Currently, only those Canadians who wish to have an unsecured mortgage, with a down payment of less than 20%, must undergo a stress test. As of January 1, 2018, when the new rules become active, all borrowers, regardless of how large of a down payment they’re willing or able to make, will need to pass a stress test.
What is a Stress Test?
When a borrower applies for a mortgage, the lender will determine if they can afford to pay back the loan based on the interest rate that is currently being offered. When a stress test is performed, the lender needs to determine if the borrower can afford both the rate that is being offered as well as either the Bank of Canada’s five-year benchmark rate or the rate being offered (the rate in the borrower’s contract) plus 2 percentage points, whichever is higher.
Keep in mind that this new rule will only apply to new mortgages and mortgage renewals where the borrowers decide to switch lenders, not mortgage renewals where the borrower stays with the same lender.
How Will This Affect You?
The purpose of these new regulations is to prevent Canadians from purchasing a house that they cannot realistically afford should the interest rate increase in the future. Currently, most experts and those in the real-estate business believe that these regulations will negatively affect the market, which will, of course, affect all Canadians. On the other hand, a mandatory stress test means that potential borrowers will need to set their sights on slightly less expensive houses as the amount they’ll qualify for will be less than they might think, or would have qualified for in previous years.