Canadians are carrying more debt than ever, with Statistics Canada reporting the average household debt ratio surging to 162.6% in Q3 2014.
And, if clients are relying on further interest rate drops to boost buying power, they could be disappointed.
That’s because a large chunk of their debt likely comes from a mortgage, and home lending rates won’t fall at levels commensurate with cuts to prime. Plus, with home prices in most markets near records (see “Average housing prices,” below), it falls to you to steer clients away from risky borrowing.
A long-applied rule says a client’s total debt-to-income ratio (including loan and credit card payments, and child or spousal support) shouldn’t be more than 36%. So, if a client’s annual income is $200,000, her maximum annual before-tax debt payment should be $72,000, or $6,000 per month. Meanwhile, her mortgage payment (including principal, interest, taxes and insurance) shouldn’t exceed 28% of gross income, or $4,667 per month.
If she has a large mortgage, show her what’ll happen when rates rise by calculating the new loan payments.
Say she has a five-year variable rate at 3% on a $400,000 loan, with a 25-year amortization. She’d pay $1,893 monthly, with $11,776 going toward interest and $10,940 toward the principal each year.
If rates rise 0.50%, she’d pay $1,997 monthly, and see her annual interest costs rise $1,959 to $13,735. Worse, she’d shave $710 off what she’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, clients need buffers.
Steve Barban of Gentry Capital in Ottawa, Ont., offers these suggestions to prepare clients for broad interest rate risk:
- Ensure they 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 clients want yield, consider buying alternatives like floating-rate bonds.
- Avoid locking in to long-term bonds until after rates have topped. If your client already has long-term bonds, sell.
- Keep equity investments in companies with strong management.
Interest rates aren’t all clients have to worry about. There’s also situational risk, like employment status. Is your client’s job secure? Does it offer growth opportunities?
Notes Barban, “The perfect storm occurs when interest rates spike, a client loses her job, has no short-term reserve and her equity portfolio drops.”
|Average Housing Prices by Province|
|Source: Canadian Real Estate Association|
|Province||December 2013||December 2014|
|Newfoundland & Labrador||$289,279||$273,769|
|Prince Edward Island||$149,021||$169,877|