How much of a difference will the interest hike make for a mortgage?
On July 12, 2017, the Bank of Canada did something it hadn’t done for almost seven years – it raised interest rates. Canada’s central bank put up the overnight lending rate (the interest rate banks lend to money to one another at) by 25 basis points from 0.5 percent to 0.75 percent. This didn’t come as a shock; the media had been speculating for weeks about a hike in interest rates. With strong employment numbers and decent GDP growth, the Bank of Canada felt the timing was right.
The Bank of Canada is trying to bring interest rates back up from its two surprise interest rate cuts in 2015. Higher interest rates give the Bank of Canada a bit of a cushion in case we have another economic shock in the future.
While the overnight lending rate matters for the big banks, what most Canadians are concerned about is prime rate. Prime rate is the lowest interest rate offered by lenders to their most creditworthy clients. Although not directly tied to the overnight lending rate, prime rate generally moves in the same direction as the overnight lending rate. For example, when the Bank of Canada raised the overnight lending rate on July 12, the big banks all raised prime rate 25 basis points the following day. Prime rate went from 2.7 percent to 2.95 percent at most lenders.
Why does a hike in prime rate matter?
Why does a hike in prime rate matter? Because it affects borrowers. Anyone with any borrowing products tied to prime rate – student loans, lines of credit and mortgage – will be affected by higher interest rates. More of your money will go towards interest and less towards principal. Furthermore, unless you increase your regular payment, it will take you longer to pay off your loan, effectively costing you more in interest in the long-run.
Let’s talk about mortgages, the single biggest debt in the lives of most. If you have a fixed rate mortgage, you can breathe a sigh of relief. Higher interest rates won’t affect you since your mortgage rate stays the same for the term of your mortgage. You’ll only be affected once your mortgage comes up for renewal.
If you have a variable rate mortgage, it’s another story. The mortgage rate on a variable rate mortgage is based on prime plus/minus a spread. For example, if your mortgage is prime minus 0.6 percent and prime rate is 2.70 percent, your mortgage rate would be 2.10 percent. But if prime rate goes up, your new mortgage rate would be 25 basis points higher – 2.35 percent.
How much does it matter for my mortgage?
To understand how higher mortgage rates impact you, it helps to run through a couple examples. Let’s say you have a variable rate mortgage at 2.10 percent amortized over 25 years and you make mortgage payments of $1,500 per month. If prime rate goes up 25 basis points to 2.35 percent, your new mortgage payment would be $1,543 per month, an increase of $43.
The bigger your mortgage, the more of your money will go towards interest. Let’s say that you own a home in a pricey real estate market like Toronto. Your mortgage rates are the same as the above example, but your payments are higher at $2,500 per month. If prime rate goes up by 25 basis points, your new mortgage payment would be $2,571 percent, an increase of $71.
Interest rates aren’t likely to be low forever, so plan ahead. By paying your mortgage as if rates are higher today, you’ll be prepared when higher mortgage rates do eventually arrive.