Mortgage-rate rise means borrowers' party is almost over

Increase creates a dilemma for prospective homebuyers

Without announcing last call, Canadian banks have taken the punch bowl away from the mortgage party that millions have enjoyed, and hangovers are looming.

Last summer, the Bank of Canada and Federal Reserve in the United States said their overnight lending interest rates would remain near zero until at least the middle of this year. The reaction by Canadians was to buy houses with rates at historic lows, and party on.

But as economies in North America began rebounding, central banks hinted rate increases could occur fairly soon, especially in Canada.

Bond rates rose in anticipation and that was the catalyst for banks to lift five-year mortgage interest rates, generally by 0.6 per cent -- the greatest single-day hike since 1994 -- to 5.85 per cent. That's an increase of $88 in monthly payments on a $250,000 mortgage for 25 years.

And they've only just begun. The C.D. Howe Institute think-tank suggests the Bank of Canada should raise its overnight rate by 1.75 per cent in the next year, likely lifting five-year mortgage rates to 7.0 per cent, while other economists envision a five-year rate as high as 8.25 per cent in two years.

That presents a dilemma for prospective homebuyers. Should they join an anticipated rush to purchase homes now and lock in at low rates, although housing prices could climb immediately with a blip in buyers during this period? Or should they wait for the frenzy to die down, expecting house prices to be lower in 12 months than they will be in three, even though mortgage rates will be higher a year down the line?

A major consideration should be whether you think you can handle lower mortgage rates now in this recovering economy better or worse than you would be able to handle higher payments a year from now when the economy, we hope, has improved and the employment situation has stabilized somewhat.

The Conference Board of Canada released a report saying one-fifth of Canadians already cannot afford both good-quality housing and either nutritious food or healthy recreational activity.

And the Bank of Canada reported that if mortgage and consumer credit interest rates went up one per cent, a record-high 9.6 per cent of households would be deemed financially vulnerable.

The question is whether we will pass the tipping point from people being unable to get into the housing market to the state where existing homeowners are unable to keep the roofs over their heads. You don't need long memories to recall how prolonged low interest rates after the 2001 terrorist attacks in the United States eventually led to massive foreclosures there when homeowners couldn't afford payments once rates rose.

Finance Prof. Moshe Milevsky with York University in Toronto says that instead of just considering financial savings in whether to have a short-term variable or long-term fixed mortgage, a person should also consider debating whether going with a short-term mortgage will leave a person unable to qualify for renewal, say if they lose their job, at variable and short-term rates.

Adrian Mastracci, with KCM Wealth Management in Vancouver, says: "If you can stand the inevitability of higher payments, a variable rate can still make sense.

"But those that have no wiggle room on increased payments should look at a five-year rate."

He also suggests paying down lines of credit aggressively before rates climb, investigating the penalty to refinance your mortgage at a lower rate if possible, considering a mortgage that is partly fixed and partly variable, and shopping around and negotiating for the best rates.

With rates so low, financial institutions had little wiggle room to offer valued clients lower-than-posted mortgage rates, but that expands as posted rates go up.

And that segues into one of the three mortgage changes the federal government brings into force later this month. In the past, borrowers had to make enough family income to pay the three-year fixed mortgage rate to qualify for a mortgage, and the new rules mean you will have to earn enough family income to handle the five-year fixed rate. TD Bank said a person wanting a mortgage on a $337,000 home would need to make another $9,200 in household income to qualify. It will be more than that with the higher five-year rates.

But one question has been whether the qualifying standard would be based on the posted five-year-fixed rate, or on an actual reduced rate a borrower might get. A document by the Canada Mortgage and Housing Corp. suggests the lower actual rate would be used.

Even so, it is suggested some people wanting to lock in long-term may no longer qualify for a variable-rate mortgage or a term of less than five years.

On the positive side of rising interest charges, a widening spread between borrowing and lending rates means bank shares should do well and they may be able to increase dividends.

And for investors who turned to safety amid the volatility of equity markets in recent years, rising rates should start to improve returns on vehicles like guaranteed investment certificates and money market funds and high-interest bank accounts.

For borrowers, the party's almost over, but for many lenders it's only just begun.