Prepare for interest rate risk

Canadians are carrying more debt than ever, with Statistics Canada reporting the average household debt ratio surging to 164.6% in Q2 2015.

And, if you’re relying on further interest rate drops to boost buying power, you could be disappointed.

That’s because a large chunk of your debt likely comes from a mortgage, and home-lending rates may not fall at levels commensurate with cuts to prime. Plus, with home prices in most markets near records, it falls to you to steer clear of risky borrowing.

A long-applied rule says your total debt-to-income ratio (including loan and credit card payments, and child or spousal support) shouldn’t be more than 36%. So, if your annual income is $200,000, your maximum annual before-tax debt payment should be $72,000, or $6,000 per month. Meanwhile, your mortgage payment (including principal, interest, taxes and insurance) shouldn’t exceed 28% of gross income, or $4,667 per month.

If you have a large mortgage, consider what’ll happen when rates rise by calculating the new loan payments.

Say you have a five-year variable rate at 3% on a $400,000 loan, with a 25-year amortization. You’d pay $1,893 monthly, with $11,776 going toward interest and $10,940 toward the principal each year.

If rates rise 0.50%, you’d pay $1,997 monthly, and see your annual interest costs rise $1,959 to $13,735. Worse, you’d shave $710 off what you’d been paying annually toward the principal.

While the $1,248 annual difference in mortgage payments may not seem high, it can add up, especially if rates rise further or the loan is on a million-dollar property. To be safe, you need a buffer.

Steve Barban of Gentry Capital in Ottawa, Ont., offers these suggestions to prepare for broad interest rate risk:

• Ensure you can afford shifting mortgage payments by running a stress test at various rate increases: 0.50%, 1% and 1.5%.
• Owning fixed income means more rate exposure. If you want yield, consider buying alternatives like floating-rate bonds.
• Avoid locking in to long-term bonds until after rates have topped. If you already have long-term bonds, sell.
• Keep equity investments in companies with strong management.

Interest rates aren’t all you have to worry about. There’s also situational risk, like employment status. Is your job secure? Does it offer growth opportunities?

Notes Barban, “The perfect storm occurs when interest rates spike, a [person] loses her job, has no short-term reserve and her equity portfolio drops.”