At the time of writing, an adjustable rate $364,000 mortgage loan costs 57% more than it did 16 months ago. That’s a taste of interest rate risk materializing.
I know a few homeowners and landlords who felt the string of interest rate hikes in 2022 & 2023. Myself included, as I intend to buy a house this year. Even renters (like me) feel the second-order effects of rate hikes.
Although recent rate hikes are tough on many households, I think recent it’s an excellent learning opportunity to help inform future decisions.
When mortgage interest rates increase, you pay more interest on the loan. Monthly payments for the same loan increase, and demand for homes drops. When demand falls, real estate prices fall. Therefore, rate risk can affect those who are mortgage-free.
Renters also feel the burn of rate hikes. More expensive ownership costs force potential buyers into the rental market. At the same time, landlords have to cover higher mortgage payments. Both factors impart upward pressure on rent prices.
In this post, I share what I’ve learned to help you manage interest rate risk as a homeowner, landlord or renter.
Table of Contents
Meaning Of Interest Rate Risk
Interest rate risk is “uncertainty in future debt payments.” Like other types of risk, uncertainty can be good or bad, depending on if rates go up or down.
Let’s assume you owe the bank $10,000. At a 1% interest rate, you only pay $100/year of interest. But if rates jump to 5%, you’ll owe $500/year—a big difference.
My example above is direct, but there are indirect exposures to interest rate risk. For example, increasing rates can cause the following:
- Higher mortgage payments
- Drop in price of real-estate
- Higher rent prices
- Higher eviction risk for renters
- Drop in bond prices (but higher future bond returns)
- Drop in price of growth stocks
I will only discuss the items in bold. The last two points don’t relate to shelter costs.
Mortgage Payments: Rate Sensitivity
I was tinkering in Excel and built the plot below to show how monthly mortgage payments change with interest rates. I used the average Canadian mortgage loan size of $370,000.
This “rate sensitivity analysis” is essential for homeowners to understand. A good advisor will cover interest rate sensitivity in financial plans for homeowners and rental property investors.
You can conduct your own sensitivity analysis by inputting different interest rates into a mortgage calculator. From here, you can find the interest rate where you start to get uncomfortable with your monthly cashflow.
Starting Point: The Overnight Rate
Rate hikes all start when the central bank raises the overnight rate.
The big banks, like RBC for example, borrow money from the central bank at the overnight rate. To remain profitable, the major banks must charge the consumer (that’s you) a higher interest rate.
Therefore, the big banks set higher rates than the central bank rate, called the prime rate. This prime rate is directly linked to the central bank’s overnight rate.
For example, if the central bank raises rates by 1%, the prime rate will also increase by 1%.
The prime rate also drives interest rates on the following:
- Lines of credit
- Variable and adjustable rate mortgages
Why Raise Rates
But why do central banks raise rates?
Central banks raise rates to control inflation. Higher interest rates make borrowing more expensive. In turn, the demand for goods/services declines. With lower demand, prices don’t increase as fast. Therefore, inflation declines.
Higher than expected inflation => Increased Rates => Increased debt payments for you.
I think it’s neat how interest rate risk is highly correlated with inflationary risk.
As you can see below, overnight rates have fallen since the 1980s. The last time we saw rates rise like 2022 was in the early 2000s
The near-zero rates seen since the 2010s were not “normal.” Relative to history, rates in the 2010s were just super low.
Low rates for the last decade adversely affected consumer financial behaviours, such as using HELOCs to buy luxury vehicles. This topic is deserving of a stand-alone post.
When people say rates will be low forever, I think they are anchored on the last decade. Overnight rates of around 5% are more reflective of “normal.”
Rate Risk With Adjustable Rate Mortgages
Interest rates on adjustable and variable rate mortgages respond immediately to central bank rate changes.
Suppose the central bank raises rates by 0.5%. Your mortgage (variable or adjustable) mortgage rate will also increase by 0.5%.
But how does this relate to monthly payments? This is where variable and adjustable-rate mortgages differ:
- Adjustable-rate mortgages. The monthly payment will immediately change in response to rate changes.
- Variable-rate mortgage. Your monthly payment stays the same, but a larger part of your payment goes towards interest, and less goes toward the principal.
As a rule of thumb, the interest rates on an adjustable and variable mortgage equal the Bank of Canada (BoC) overnight rate + 1.75%. The buffer allows ordinary banks to make some profit by lending you money.
For an example of variable/adjustable rate increases, let’s look at the BoC’s rate hikes taken directly from the Bank of Canada’s Website.
Interest Rate Risk Example: Adjustable Rate
Consider an adjustable rate mortgage in 2021 when the BoC rate was 0.25%. At this point, a variable rate of 2% was not uncommon (0.25% + 1.75%).
But then inflation hit, and the BoC started a series of rate hikes to cool inflation. The central bank increased rates from 0.25% to 4.5%.
As central bank rates changed, so did rates for variable and adjustable rate mortgages:
Adjustable Rate Mortgage Rate Hike Example
The average mortgage amount in Canada is $364k. An adjustable-rate mortgage at 2% had a $1,540/month payment in 2022.
One year later, the interest rate was 6.25%, with a payment of $2,383. For a more refined sensitivity analysis, check out the below chart from the Financial Consumer Agency of Canada.
Rate Risk For Variable Rate Mortgages
Variable-rate mortgages are similar to adjustable-rate mortgages. They differ in one critical way. With a variable-rate mortgage, the payment stays the same when rates increase, up to a point.
Variable-rate mortgages may seem “safer” since the payments don’t change.
But don’t be fooled; you still eat the cost of rate hikes. As rates rise, more of the fixed payment goes towards interest, extending the payback period.
The plot below from the Bank of Canada (source) shows how the fraction of interest to principal changes as interest rates change.
In addition, payments for variable rate mortgages can go up once you hit the dreaded trigger rate. This is the point where you are now paying 100% interest.
At this point, your mortgage payments will need to increase so you can pay down at least some principal. Otherwise, you’ll be digging yourself deeper into debt each month (compound effect in the wrong direction).
Adjustable Rate Superiority
I prefer adjustable-rate mortgages over variable-rate mortgages. Adjustable rate mortgages do not mask rate hikes and you feel the interest rate increase immediately.
On the other hand, a variable rate mortgage delays the pain of rate hikes into the future. This is the opposite of delayed gratification, which is critical to building wealth.
Adjustable rate variable mortgages keep you grounded in reality. If you want a regular mortgage payment at a fixed interest rate, why not just get a fixed-rate mortgage?
That’s better than masking the salience of rate risk under a variable rate product, in my opinion.
Interest Rate Risk: Fixed Rate Mortgages
Fixed-rate mortgages protect you from rate risk for a fixed period of time (equal to the term).
But this comes at a premium in the form of higher interest rates. It’s the price you pay to reduce your interest rate risk.
“But Jake, fixed rates are lower than variable rates!”
Right now, this is true. But the markets, rather than the central bank, set long-term rates. When the long-term rate is more than the short-term rate, it means that the market expects the central banks to reduce rates in the future, dragging variable rates down as well.
Put simply, if you have a 5% fixed rate for 5 years, it means that the market expects variable rates to fall below 5% for a large portion of the next five years.
If the banks thought that rates would stay at 6.5% for the next five years, then your 5-year fixed rate would be above 6.5%.
Rate Risk Example: Fixed Term Mortgage
I assume you have a $370,000 mortgage you were fortunate to lock in at a 2% interest rate in 2021 for a 5 year term. This loan costs you $1,567/month. Cool.
You are safe until 2026, when your mortgage term renews. At this point, you may need to renew at a higher rate.
But, I’ll assume that the 5-year mortgage rate will be 5% in 2026 (no one knows exactly what it will be). Therefore, you will renew your mortgage at 5%. Your monthly mortgage payments will increase from $1,567 (2% rate) to $2,152 (5% rate).
Fixed rates keep you safe from interest rate risk for the duration of the term. When the term is over, you are again exposed to interest rate risk.
Interest Rate Risk: Landlords
Mortgage interest is a considerable cost for landlords. When rates go up, rent payments may no longer cover the landlords costs. At this point, the rental property becomes a questionable investment and can erode net worth.
For example, check out the below assessment for a rental property investor who owns a $600,000 home that rents for $2,600/month.
At a 2% interest rate, the landlord is okay becuase the rent ($2,600/month) covers the total costs ($2,267/month).
Now let’s see what happens when interest rates go up to 6% (as they did in 2022). Now the total cost of ownership has increased by $1,600 per month.
Due to rent caps, the landlord can’t increase rent. The landlord eats the interest rate risk.
After a rate hike to 6%, the rental property now costs the landlord $3,870/month while rental revenue is $2,600/month. At the same time, the home value is falling. Additionally, the landlord still incurs vacancy risk and building maintenance risks.
Before becoming a landlord, finding your “break-even” interest rate is a great idea.
For more on the costs of homeownership, including the elusive opportunity cost of equity, you can check out my rent vs buy post.
Interest Rate Risk For Renters
Renters (like me) may avoid interest rate risk directly. But us renters are still indirectly exposed to interest rate risk in the following ways:
- Some potential home buyers can no longer afford to buy. They are squeezed into the rental market. Demand for rental properties goes up.
- Mortgage costs increase for landlords. To remain profitable, the landlord must increase rent prices. Eventually, landlords pass their costs along to renters as fair compensation for taking risk …
- Debt is more expensive, making it more costly to modify homes into a duplex or triplex. It is, therefore, harder for landlords to increase the supply of rental units.
From Interest Rate Risk to Eviction Risk
If landlords can’t increase rent prices due to rent caps, they are incentivized to sell the house or evict existing tenants to “renovate.”
After the reno, they can list the renal property at the market rate. It seems that interest rate risk can transform into eviction risk.
How to Perform an Interest Rate Risk Sensitivity Analysis
There are two main ways to perform a sensitivity analysis:
- I use a mortgage calculator to see how monthly debt payments change with interest rates.
y, you can use the PMT function in Excel to figure out mortgage payments based on interest rates. From here, you can find the highest interest rate that you can afford. For landlords, I’ll call this the break-even rate, where net cash flow equals zero.
Homeowners may want to compare it to the rule of thumb of contributing no more than 30% of (pre-tax) monthly income towards home ownership.
Now, you can make an informed decision as a homeowner or investor. I also suggest you understand interest rate history to appreciate the risk of home ownership.
Speculative Homebuying Fever
Consider what happens when interest rates fall, like they have been since the 1980s. Monthly payments become cheaper, housing demand goes up, and house prices increase faster than normal.
Peter Lynch notes that many buy assets “because the sucker is going up.”
From what I saw in Ontario last few years, people were buying houses for this reason, expecting 10%+ annual growth. This can lead some to buy too much house, viewing it as an “investment”, while disregarding significant cash outflows for land transfer tax, property tax, home maintenance, utilites, and realtor fees upon selling.
It can even lead landlords to buy rental properties that are cashflow negative in hopes that appreciation will outweigh negative cashflow.
A good expectation for residential real estate appreciation is 1.5% per year, adjusted for inflation (source). That’s about 4.2%/year without inflation adjustment.
You may be healthy at a 2% rate, but what about an 8% rate?
At what interest rate does your rental property become unprofitable, or at what rate do your home ownership costs exceed 50% of your household income?
These questions can be answered with a simple interest rate risk sensitivity analysis. A good advisor can help you with both.
Finally, you may be able to reduce interest rate risk by renting or owning a home outright. Additionally, you can pay a premium via a fixed rate mortgage to reduce rate risk. But you can never escape interest rate risk entirely.
If you want to meet to discuss interest rate risk in more detail, don’t hesitate to book a quick chat.