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Risks rising for Canadians borrowing against their homes

Dale Jackson
Pay Day
Sale signs line homes surrounded by slag heaps in Thetford Mines, Quebec, February 12, 2012. REUTERS/Christinne Muschi

We’ve been hearing a lot about the risks young homeowners face from rising mortgage rates. But the risks are literally compounded for older homeowners with reverse mortgages and home equity lines of credit.

All borrowers are at risk

Mortgage rates may ebb and flow in the short term but most economists agree rock-bottom borrowing rates have nowhere to go but up. It’s just a question of when.

For homeowners with variable rate mortgages that means getting zapped financially each time the Bank of Canada raises rates to cool inflation, and the banks follow the lead.

As an example, if you owe $300,000 and payments are spread out over 20 years at a mortgage rate of 3 per cent, your bi-weekly payment would be $765. If that rate increases to 5 per cent that same bi-weekly payment rises to $910. That extra $110 in interest payments every month could strain a household budget.

BMO recently joined the ranks of many lenders by slashing fixed rate mortgages to help sway homeowners to lock in. In most cases fixed rates are higher than the going variable rate, and higher rates will still be waiting for them when the term is up.

Either way, as time goes on interest compounds. That means borrowers are not only charged higher interest on the principal, but higher interest on the interest, higher interest on that interest, and so on.

Retirees up against the wall

The good news for conventional mortgage holders is each mortgage payment lowers the principal slightly. As the principal falls over time, the total interest costs also fall.

That’s not the case for retirees who rely on reverse mortgages or home equity lines of credit for their day-to-day living expenses. In addition to interest compounding on the amount they borrow against their homes, the amount they are borrowing is also growing. That additional principal accumulates its own compound interest.

Young homeowners hit by higher mortgage rates have the option of trimming expenses, generating more income, stretching out their amortization period or putting their savings on hold.

Most retirees on a fixed income don’t have those options. They risk outliving their assets.

Stretching your home equity

In most cases homeowners can borrow up to half of their home’s appraised value through a reverse mortgage. Keeping at least half of the home’s equity gives reverse mortgage providers a comfortable buffer in the event the house looses value or interest charges snowball. When the house is sold the loan is paid back first, and the rest goes to other creditors and the owner’s estate.

One way to keep interest from accumulating is to make payments on the interest only, and allow the principal to grow on its own. That could mean dipping into savings in registered retirement savings plans (RRSPs) or registered retirement income funds. Debt has a nasty habit of sucking the growth out of any investments anyway, and it’s safer to use savings to pay down debt than risk it in the markets.

Another option is to revert to a home equity line of credit with the bank using the house as collateral. Homeowners can access as much as 80 per cent of the appraised value or purchase price of the home (whichever is less).

In addition to leveraging a larger portion of the property, a home equity line of credit permits homeowners to save on interest charges by only taking money as they need it.

A typical rate for a home equity line of credit is the bank prime rate plus 1 per cent, which is currently 4 per cent.

In the case of both reverse mortgages and home equity lines of credit there is often the option of converting to a fixed rate to stem the tide of rising interest rates.