Can your client afford a mortgage as rates rise?

On Wednesday, Canada’s big banks raised their prime rates following a rate hike by the Bank of Canada (BoC).

The banks’ prime rate is now 3.95%, which will affect mortgages rates.

For clients with variable-rate mortgages, most providers won’t increase payments right away, says BMO on its website. “Instead, you’ll pay the same amount as before the rate increase, but less of each payment would go toward the principle,” it says.

For such clients to sustain their amortization periods, BMO suggests three choices: increase monthly payments immediately or when the mortgage term ends, make one or more lump-sum payments, or do nothing. With the last option, clients would still have to increase monthly payments or make a lump-sum payment once their mortgage terms end to stay on schedule.

For new homebuyers with down payments of 20% or more (uninsured or low-ratio mortgages), mortgage rules require a stress test that determines whether clients could afford their mortgages if rates increased. The stress test uses the higher of either the five-year benchmark rate published by the Bank of Canada or the lender interest rate plus 2%.

For high-ratio mortgages (down payment of less than 20%), clients must qualify using the higher of the Bank of Canada five-year benchmark rate or the lender’s rate.

The stress test applies to mortgages at federally regulated institutions, not credit unions and private lenders.

The Bank of Canada’s benchmark rate is 5.34%, and the best bank rate on ratehub.ca Thursday for a five-year fixed mortgage is 3.49%. Assuming a client were to receive this rate, they’d have to qualify for their mortgage at 5.49%.

Even in the best of circumstances, a large increase in mortgage rates could prove a lot to handle for some clients, says BMO on its website. For example, depending on income and mortgage size, a 2% increase, represented in the stress test, could leave a client with a significant proportion of their income spent on housing. See BMO’s website for an example.

BMO is calling for three more BoC rate hikes through 2019. With a more hawkish tone from the central bank Wednesday, “expect rates to continue to push higher at least through early 2019,” says a BMO report.

A BMO survey earlier this year found that most new homebuyers were influenced by rising mortgage rates, with 51% saying the type of mortgage they’d choose would be based on rates. Nearly one-third (30%) said they’d likely go for a fixed-rate mortgage, and 5% said variable rate. Only 13% said interest rates would have no influence on mortgage type.

Read: Effects for clients as interest rates rise

Mortgage rules and the economy

In its latest monetary policy report (MPR), the Bank of Canada says mortgage rules enacted over the last two years, along with higher interest rates, have reduced household debt vulnerability.

Household credit growth has declined, and the quality of new mortgage lending has improved since the rules took effect. For example, new low-ratio mortgages declined by about 15% in the second quarter of 2018 relative to the same quarter in 2017.

In fact, loan activity fell among all borrowers, with the largest drop exhibited among new borrowers with a loan-to-income ratio above 450%.

The drop means there are fewer new, highly indebted households, says the BoC. Still, vulnerability associated with household indebtedness will persist because of the sheer size of that debt, it says.

Also read:

What’s in store for Canada’s condo market