With Mortgage Rates Rising, Revisit Financial Plans

With the Bank of Canada recently announcing another 100 bps increase in the overnight rate to 2.5%, clients are asking more and more about how this will affect their mortgages, the impact to their cash flow, and ultimately the impact to their overall financial plans.  

While cash flow may not be immediately affected by the recent changes for most clients, financial plans created making long-term projections carrying the current term rate forward for the life of the mortgage should be reviewed because the illustrated amortization is likely no longer reasonable. Further, if the cash flow freed up once the mortgage was projected to be paid was assumed to be put towards another goal, that secondary goal will also need review.

If a borrower has a mortgage with a variable rate, their bank will be adjusting the interest rate applied towards the outstanding balance.    If the variable rate mortgage is an ARM (Adjustable-Rate Mortgage), the payment will change with each increase to reflect the higher interest costs.    

For example, I spoke with a mortgage broker, Jason Wermie, to discuss a hypothetical impact.  He explained, “for a client with a $360,000 mortgage paying $1667 per month for a 25-year amortization prior to the increase, their payments may increase to $1855 per month.”  That’s roughly an 11.3% increase to their payments, which can obviously have a serious impact on their immediate cash flow.

Most borrowers with variable interest rates are not set up as ARM, and therefore they likely will not experience an immediate change to their monthly cash flow; however, the amount of their payments being applied towards the principal of the mortgage will decrease with each corresponding increase in interest rates.  These variable rate mortgages typically have a clause that allows the lender to increase payments if the underlying rate reaches a certain threshold called a “trigger rate”.  Clients can review their mortgage contract to find the trigger rate for their mortgage.  Once the mortgage term ends, the payments may need to increase to maintain an allowable amortization on the outstanding mortgage balance.

For borrowers with fixed rate mortgages, no changes to the payments will occur until the mortgage comes up for renewal at the end of the fixed term.  At that point, to maintain the same amortization schedule, the borrower will need to increase their mortgage payments to reflect the higher rates available for the next term.

With the potential for mortgage payments to significantly rise over the next few years for many clients as their mortgages renew, budgets will need to be revisited to ensure savings assumptions for long-term goals remain realistic.  This conversation should start today because clients may be tempted to increase their mortgage amortization at renewal to maintain a payment similar to what they are used to in order to continue to fund other goals. 

As a financial advisor, you will need to help the client evaluate the impact of this decision as this will impact their long-term financial success.  Risk tolerance discussions will need to occur to discuss the suitability of reallocating dollars from debt payment to savings, as this could be considered leveraged investing.

At the same time, as we are living through a period of higher inflation, clients may be more comfortable maintaining the lower payments for shelter as they deal with the uncertainty associated with rising prices for food, energy, and, well, pretty much everything else.

A recommendation, therefore, may be to consider mortgages that allow you options such as: increasing mortgage payments during the term, making double-up payments, and making lump-sum payments against the principal without incurring a penalty.  This may allow the client to start with a payment that is comfortable today, with the goal of increasing the payments over time as their income increases.

Ian Wood is Vice-President and Associate Portfolio Manager with Cardinal Capital Management in Winnipeg.  As a financial planner, he works directly with clients across Canada and the US, specializing in the areas of business succession, retirement income planning, and estate planning.