In debt? How to deal with the shock of rising interest rates

We’re expecting rise in interest rates this year, and for Canadians carrying consumer debt, that means higher payments across the board.

It’s not just variable rate mortgages that will go up, but also lines of credit, consumer loans, some car loans; credit-card rates will likely follow suit.

“I think the majority of Canadians can absorb a 0.5 per cent interest rate increase, but those who are financially overextended don’t have much wiggle room and may be pushed to their limits and face financial difficulty,” says Marie Engen, fee-only advisor at Boomer & Echo. “Cash-strapped consumers will have to cut non-essential spending and reduce their savings.”

Lise Andreana, certified financial planner at Burlington, Ont.’s, Continuum II Inc., says with Canada’s average household debt already sky-high, those already owing large amounts could be in trouble.

“My fear is that many young families have a total debt level which is much higher than 162.6 per cent and may exceed 180 per cent,” Andreana says.

"The way I see it, those Canadians most at risk are young families whose debt levels are already very high; single-parent families with an average family income in the $40,000 range; and retirees on a fixed income, some of which may not be linked to inflation, who have debt. Some retirees have retired with a mortgage. Scary.”

Here’s a breakdown of how an interest-rate hike could play out in real terms:

• A $400,000 mortgage with a 25-year amortization and a floating rate of 2.25 per cent would mean current payments of $1,744.52 per month. A 50-basis point increase would see this go to $1845.24, an increase of $100.72

• A $20,000 car loan at 5 per cent now with a five-year payment period has a monthly payment of $377.47. An increase to 5.5 per cent would move to $382.02, an increase of $4.55.

• A credit-card balance of $10,000 at 18 per cent costs $150 per month. At 18.5 per cent, that jumps to $154.17, an increase of $4.17.

The total increase in costs for this family with a household debt of $430,000 would go from $2,271.97 to $2,381.42.

“A 50-basis point increase in 2015 could be quickly followed by another and another,” Andreana says.

There are ways to manage debt in an era of rising interest rates.

“You need to ensure you can manage future increases in debt payments and stay within your comfort zone,” Engen says, noting that high-interest credit-card debt should be attacked first over products with lower interest rates. Consolidating debt is another option to consider.

Planning ahead is vital

“Canadian families should sit down soon to discuss their financial situation and do a review of all their sources of debt, the costs, and options for reducing the debt with the highest interest rates first,” Andreana says.

While a rise in interest rates may see lots of Canadians rush to buy a home to lock in before they get even higher, Andreana says to use caution.

“Before committing to a new home purchase, carefully consider all the costs and the impact of rising interest rates,” she says. “Test out your potential loan by asking your lender how much your payments would go up if rates increased by a full 1 per cent and 2 per cent. Can you still afford this?

“[Governor of the Bank of Canada] Steven Poloz and others have indicated that Canada is in the middle of a housing bubble with current prices somewhere between 20 and 30 per cent over fair market value,” Andreana adds.

“For the average new home buyer who puts down a deposit of 25 per cent, it would not take much for these new home buyers to see a total loss of their home equity as real estate values drop and their mortgage rates begin to creep up.”

People who already have mortgages may want to increase the frequency of their payments from once a month to twice monthly or weekly, Andreana says, or reduce the amortization from 25 years to 20 years or less, assuming it’s affordable, so they can chip away at their debt principle.

Those thinking of a new car want to proceed carefully, too. Andreana suggests consider borrowing through the car dealer if there are specials on like zero-interest loans.

Sometimes, leasing makes sense.

“I know there is an interest rate imbedded in the lease price, but the monthly payments can be significantly lower than buying and borrowing. Using this monthly saving differential to up size your car purchase is cheating. The goal is to keep monthly costs as low as possible so the savings can be applied to other debt reductions strategies.”