The real cost to you from higher interest rates
Canadians have seen interest rates rise considerably this year and those not on a fixed interest rate mortgage have seen their regular mortgage payments rise along with them. All the talk in the media, and rightfully so, is about the rise in mortgage payments, but what often gets overlooked is the longer-term impact to your financial health and retirement savings.
We have all heard stories about mortgage payments rising by $1,000 per month, but what about the impact of higher interest rates to service a mortgage over its lifetime?
To answer this question, I looked at the difference in mortgage interest costs over the lifetime of a mortgage taken at the start of 2022 (Scenario 1) compared to one taken today (Scenario 2). I used $500,000 as the mortgage amount and a 25-year mortgage amortization.
At the start of the year, the 5-year fixed mortgage rate was 2.69%. Today the rate for the same mortgage is 4.94%.
If we compare the two scenarios, the total interest costs on the mortgage over just the 5-year term goes from $62,042 in Scenario 1 to $115,577 for Scenario 2 - a jump of over 86%.
Looking at the full 25 years, the lifetime interest costs on the mortgage goes from $186,224 to an astonishing $367,288 - a jump of over 97% - almost double! Or put another way, over 73% of the original mortgage amount is paid back as interest. Clearly, this will make quite a negative dent to one's potential retirement savings.
Now let's look at how much extra of a borrower's after-tax (net) income will be required to pay for the extra interest costs on this mortgage due to higher rates.
At the start of the year when the interest rate was 2.69%, to qualify for a $500,000 mortgage, a borrower needed a pre-tax income of $106,000 The after-tax income for this borrower living in Ontario is $76,562. This means 2.43 times of the borrower's annual net income was required to pay for the lifetime interest costs ($186,224) of the mortgage.
Today, when the interest rate is 4.94%, a pre-tax income of just over $122,000 is needed to qualify for a $500,000 mortgage, leaving a net income for this borrower living in Ontario of $85,617. This means a whopping 4.29 times the borrower's annual net income will be required to pay for the lifetime mortgage interest costs ($367,288).
Next, if we look at the disposable income left over after paying the mortgage, property taxes, and home heating bills in both scenarios, the borrower in Scenario 1 earning a net income of $76,562 has $44,913 left to use on all other expenses, whereas, the borrower in Scenario 2 earning a net income of $85,617 has $46,725 left to use on all other expenses - a difference of only $1,812.
This means, all else equal, the borrower in Scenario 2 has only $1,812 extra each year to service the additional lifetime interest of $181,063 or the equivalent of 99 years. Given that the borrower has only 25 years to service the debt and not 99 years, the borrower will need to service the higher interest payments will be left with a lower disposable income than the borrower in Scenario 1. The borrower in Scenario 2 will need to sacrifice savings to their retirement fund while being subjected to a reduced standard of living just to pay for the higher interest costs on their mortgage!
Not only that, even if interest rates return back to early 2022 levels at the time of renewal, the borrower in Scenario 2 will have paid $10,707 extra each year in interest in the first 5 years.
The silver lining is that higher interest rates generally mean lower real estate prices. The borrower in Scenario 2 can offset some of the negative effects of higher rates by purchasing a home that was valued at $500,000 at the start of 2022, but has now gone down in value. Doing this means not utilizing their maximum qualifying amount. For example, if house prices have gone down by 20%, then the borrower in Scenario 2 should consider purchasing a home where only a $400,000 mortgage or less is required (not $500,000). Unfortunately, in my experience, many homebuyers do not behave this way.
Sadly, this depth of analysis goes unreported by the financial media and many mortgage advisors do not take into account the impact of higher interest rates on mortgages to your overall financial health.
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