Remember as a child imagining what your home would look like when you were all grown up? It was big, maybe with a pool in the backyard, and extra guest bedrooms for friends. Now you might find a modest two-bedroom bungalow is unaffordable!
You’re not alone. A growing number of Canadians feel like they cannot afford the house they own. The reason? Inflation and the resulting rise in interest rates.
How does inflation affect interest rates?
To understand the link between inflation and interest rates, let’s first look at inflation. Inflation occurs when the price of goods and services in an economy increases. The rate at which the prices increase is the inflation rate.
So, how does the rising cost of the things we buy (in other words, inflation) lead to an increase in interest rates? Well, inflation is bad news for the economy. To keep it under control, the Bank of Canada increases interest rates. This encourages people to save money, since you’ll earn more interest on your money, versus spending it.
As you reduce your spending, it will result in lowered prices of goods and services, thanks to the law of supply and demand. (If there’s no demand for a product or service, the price of that item goes down.) This leads to a halt in inflation.
As you can see, there is a direct link between inflation and interest rates. When the inflation rate goes up, interest rates also go up to contain inflation. If you’ve followed along so far, congratulations! You’re already more financially literate than 1 in 3 Canadians who don’t understand how interest rates and inflation work.
How do rising interest rates affect homeowners?
Let’s take it a step further. Why do nearly 25% of homeowners think they may be forced to sell their homes if interest rates keep rising?
Mortgage interest rates are based on the prime rate, determined by the Bank of Canada. If the prime rate increases, then the rate of lending or interest rates also increase. Similarly, if the prime rate decreases, then the interest rates also decrease.
Currently, the prime rate in Canada is the highest it has been in 10 years. That’s right, the prime rate in July 2022 is now at a whopping 4.7%, a whole percent point up from the prime rate in June 2022 which was 3.7%. That’s quite a jump for homeowners who have a variable mortgage (more on this below).
Types of mortgage interest rates
When you take out a mortgage, you can choose between a fixed mortgage interest rate (called a “fixed mortgage”) or a variable mortgage interest rate (called a “variable mortgage”).
What is a fixed mortgage?
A fixed mortgage means the interest rate does not change throughout the term of your loan. Many people choose a fixed mortgage to protect against a rise in interest rates. They enjoy a set schedule of what portion of their mortgage payment goes to the principal loan amount and what portion pays interest. The downside? If interest rates decrease, they could miss out on some savings.
What is a variable mortgage?
A variable mortgage means that the rate of interest will keep fluctuating throughout the term of the loan. When the prime rate increases, the mortgage interest rate goes up. When the prime rate falls, the mortgage interest rate also falls.
People choose a variable mortgage to take advantage of dips in interest rates. Of course, like many homeowners are discovering, a variable mortgage can also be a huge cause for concern when the interest rates increase.
You see, your monthly payments won’t change with an increase in interest rates. However, the portion of your mortgage payment that goes towards your actual loan amount will significantly decrease. Basically, your mortgage payment will only go towards paying interest on your mortgage! At the end of your mortgage term, you’ll find your loan amount won’t have decreased by much at all, leaving you in debt longer.
Tips to deal with inflation, rising interest rates, and making your mortgage payments
If you’re like many, you may worry that you might have to give up your house if interest rates increase further or are panicking about making your mortgage payments in the long term. While it is a cause for concern, we’re here for you. Here are some things you can do to reduce the costs, battle inflation, pay off your mortgage smartly, and keep your house.
Tip #1: Tweak your payment structure
When you’re paying off a loan like a mortgage, part of your payment goes toward the principal amount and another part goes toward paying interest. Speak to your advisor to get the exact breakdown of how your payments are structured. You should ideally be contributing more towards paying off your principal amount.
If you’re not able to make changes to your “official” payment structure, you can look at doing so on your own. See if your financial institution allows principal-only payments and how much you’re allowed to pay extra each month and year without penalty.
If you have a mortgage with us, you can make principal-only payments in seconds through digital banking:
- Log into digital banking
- Select Payments & Transfers > Transfers > Transfer Money
- Select the loan or mortgage you'd like to make an additional payment to
- Follow the prompts and you're set
We also have a generous 20/20 mortgage prepayment option where you could pay 20% extra each month and 20% of your original mortgage principal each year to pay down your mortgage faster.
Tip #2: Cut down on expenses and add to your savings
Remember the link between inflation and interest rates? Rates increase across the board. That means, savings or investment rates also increase which is the good news story! Take advantage of the increase if you can. Put more money in a savings account or GIC.
At the same time, cut down on unnecessary expenses. It will help you save more (and earn more in interest) on an individual level. PLUS, if spending decreases across the country, it will bring down inflation for everyone. So go ahead, chalk out that budget, and stick to it.
Tip #3: Keep learning, keep planning
To combat any concerns about your finances, the best way forward is to constantly keep learning and increasing your financial literacy. By reading this blog, you’ve already taken a step in the right direction, so keep it up! As you learn more about mortgages and other financial instruments, you will be able to determine how to save money, how to plan for the future, and budget wisely today too.
Of course, you don’t have to do this alone. Our team of financial advisors are just a call away. We can help you not just manage your mortgage payments, but even consolidate your debt, plan for your retirement, and grow your wealth. Contact us today!