06/12/2013 12:09 EDT | Updated 08/12/2013 05:12 EDT

A Dirty Little Secret About Mortgage Interest Rates

Do you like math? Many people don't, but this is important, so please play along with me while I ask this math question (and it is a trick question, so take as much time as you need to answer it):

If your mortgage interest rate goes from 3 per cent to 4 per cent, how much did it go up?

The obvious answer is 1 per cent, but that's not the answer I'm looking for to this question.

If your mortgage interest rate goes from 3 per cent to 4 per cent, your interest increased by one third, or just over 33 per cent. That's a huge increase, and that's why rising interest rates in Canada could be deadly.

On Monday June 10 TD Canada Trust announced that they were increasing the interest rate on a five year closed mortgage from 3.09 per cent to 3.29 per cent. (I'm not picking on TD Bank; at some point the other banks will also increase their lending rates; TD just happened to be the first this week).

The response from most people was "so what, it's only one fifth of one percent; it's no big deal." Perhaps, but what if this is just the start of a new trend towards higher interest rates? If we have a few more small increases, eventually they will total 1 per cent or more, and you will suddenly discover that your 3 per cent mortgage interest rate has increased to 4 per cent, and that is a big number.

That's the dirty little secret about interest rate increases: it's not the increase in the percentage rate that matters: it's the percentage increase that will squeeze your budget. A one percent increase may not seem like much, but 33 per cent is huge.

For many years the best decision a Canadian could make was to get a variable rate mortgage (not a fixed rate), because the rate was lower. That's great, but a variable rate, obviously, is variable, so it can do down, but it can also go up.

Today you may be paying 3 per cent on your variable rate mortgage, so on a $200,000 mortgage amortized over 25 years you are making a monthly payment of $946.49.

What happens if your variable interest rate was to increase by 1 per cent? Again, you may not think 1 per cent is a big number, but a 4 per cent interest rate on your $200,000 mortgage amortized over 25 years would cost you $1,052.04 per month.

Can you afford to pay an extra $105.55 per month on your mortgage? Is your after tax paycheque increasing by $105 per month this year? If not, higher interest rates will squeeze your budget. Over the life of your 25 year mortgage that extra 1 per cent will cost you $31,665.

Where will you get that extra $31,665?

Here's my advice: don't assume interest rates will stay low forever. If one bank has started increasing rates, it's likely that other banks will follow, so now is the time to consider what you will do if interest rates increase, and make a plan NOW to deal with a potential rate increase.

If you plan to live in your current house for many more years and you have a stable income, perhaps now is the time to switch from a variable rate to a locked in fixed rate. Or, if you can afford it, reduce your amortization period so you can pay off your mortgage faster and reduce the interest you pay.

If your income isn't stable, or if you plan to move, perhaps now is the time to consider selling and renting to protect yourself.

I don't know the future so I can't tell you what to do, but I can advise you to consider all options, so that you are prepared regardless of what happens to interest rates.

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