As realtors, any fluctuation with the Interest Rate can seem very worrisome, wouldn’t you agree? Let’s begin with looking at the the recent realtionship between the ineterest rate and our government.
Rising Interest Rate & Canadian Government
In the past two years, the Canadian government has done two things to help fellow Canadians get through the pandemic.
- Lots of subsidies, grants, and benefits were offered to local businesses and fellow Canadians.
- Canadian interest rates had been lowered to the historic level at 0.25% to stimulate borrowing and investing.
Our government has been incurring a substantial amount of deficit year in and year out before the pandemic emergency relief measures. With the unprecedented amount of benefits and subsidies offered during the pandemic, the Federal government had increased their deficit by twelvefold, by $274.4billion in 2020.
If you combined the Federal government deficit with the provincial, territorial and local governments, the consolidated deficit was $325.5 billion for 2020.
Have you wondered how the Canadian government can afford to have this much deficit in one year?
The simple answer is that – they don’t, they borrowed. They borrowed from the Bank of Canada. They borrowed A LOT from the Bank of Canada.
The BOC, the Central Bank of Canada, purchased bonds, treasury bills, etc. from the Government of Canada. It then turned around and offered a portion of them to the private market including banks and security traders. The BOC kept the remaining portion without offering it to the public.
Because Bank of Canada is wholly owned by the Government of Canada, for those of you who know accounting, the portion that’s kept by BOC is essentially a digital entry that’s created to increase cash, i.e. asset, and increase liability.
This is how they increase money supply in the system, a simple journal entry in accounting term – by debiting cash, crediting liability.
Because of the amount of subsidies and grants offered by the government during the pandemic, we created an unprecedented amount of debt in 2020.
With an increase in money supply over the last two years, as well as low interest rates offered by the Bank of Canada, it isn’t surprising to see that inflation surpassed 5% in January 2022.
As realtors and real estate agents, you have all seen and experienced the unhinged real estate market, partly stimulated by cheap money being offered by banks.
One of the ways that the BOC could limit inflation AND control the overheated housing market was by increasing the prime rate.
And, so they did. They announced a rate hike of 0.25% at the beginning of March, and now they have raised it last week by half a percentage point to one percent last Wednesday in its latest move to rein in high inflation.
Now you may be wondering…
Can we expect to see more hikes?
We all knew that this was coming. We just didn’t know how much increase we would see over the next year or so.
The good news is that the gradual increase in interest rates over the year to help slow inflation does not mean buyers will stop seeking a home completely.
Together with the Federal government’s decision to ban foreign investors for the next two years, there will definitely be fewer bidding wars for home buyers to be in the middle of, maybe we can even see some rare stability in the market.
We may even see some price adjustments similar to the year 2017/2018.
You’ll be surprised how many realtors / real estate agents often ask me… as a buyer, should I go with a fixed-rate or variable rate mortgage in this fluctuating market?
Locking in with a Fixed interest rate mortgage
With a fixed-rate mortgage, your interest rate and payment stay the same over the mortgage term. A fixed-rate mortgage is tied to bond rate, not Bank of Canada prime rate.
With a variable-rate mortgage, the interest rate can move up or down according to the lender’s prime interest rate, which is also tied to the Bank of Canada prime rate.
With a variable rate mortgage:
- Your initial interest rate will most likely be lower than a fixed-rate mortgage
- If the prime rate falls and your interest rate falls accordingly, your monthly mortgage payments decrease (vice versa, as the prime interest rate has increased and is expected to continue to increase). If the prime rate rises and your interest rate goes up accordingly, your monthly mortgage payments increase accordingly as well..
- You can convert to a fixed-rate mortgage at any time (especially when you know there’s going to be an expected hike in interest rates)
What this means with a fixed-rate mortgage:
- From my experience, you can expect the initial interest rate to be higher than a variable-rate mortgage.
- You’ll know when you’ll be able to pay-off your mortgage, as the interest stays the same
- You’ll have the certainty to budget for mortgage payments, knowing exactly what you have to pay each month for the duration of the term
- Mortgage penalties can be substantial if you choose to break before the end of the term
The biggest downside of locking in a fixed-rate mortgage is the cost of penalty. Penalty is often calculated as greater of
- 3 months of interest or
- Interest rate differential between your existing mortgage or their advertised rate or posted rate
This could easily amount to tens of thousands of dollars in terms of penalty.
When you commit to a fixed-rate mortgage, make sure you are not planning to 1) sell or 2) refinance within the term of your mortgage.
Here’s the little hack that I normally do – commit to variable, pay fixed-rate mortgage amount
If I were to borrow $800K from the bank to purchase a rental property, I would opt for a variable rate.
Variable-rate at 1.60% means that my monthly payment amount = $2,797.46
Fixed-rate at 2.69% means that my monthly payment = $3,234.26
If you want peace of mind, here’s what I would do…
Sign up for a variable rate mortgage, pay your monthly mortgage payment amount to the fixed-rate amount.
In my example earlier, with an $800K mortgage, the bank requires me to pay $2,797.46 if I go variable.
I would instruct the bank to make a fixed-rate mortgage payment of $3,234.26 instead – so I am already used to paying a higher monthly amount.
The extra $437 payment that I make goes toward my outstanding mortgage principal on a monthly basis.
At the end of one year, my mortgage outstanding amount is lowered by $5,306 as compared to opting in for the fixed mortgage.
My cash outflow is exactly the same, but the extra goes straight to my mortgage principal, which also carries a compound effect on my monthly mortgage payment.
By the end of the second year assuming there is no rate increase, my mortgage outstanding is lowered by $10,757 cumulatively.
If you are concerned, go for a variable-rate mortgage, but pay as if you’re committed to a fixed-rate mortgage, assuming you have an option. As you know, sometimes, we don’t have a choice but to commit to a fixed-rate mortgage.
How to Prepare for a higher Interest Rate Environment?
- Invest in cash flow positive properties
If the rental income isn’t enough to cover all expenses on its own, you should think twice before investing in the property. As a minimum, you need to generate enough cash flow from your overall portfolio to support this cash flow negative investment.
With this principle, even if there’s a rate hike, your overall portfolio can still sustain itself, without further cash flow injection from you.
Yes, you can still find cash flow positive properties. After all, you’re a realtor! I’m sure if you look hard enough and be more creative, even in this scarce market, there’s something for you out there.
We bought a couple of properties in 2017/2018 just before the “market downturn”. We bought at the peak that year. I remember questioning why we committed to purchase these properties when they were priced at the top.
Thankfully, they have been cash flowing positive from day 1, even though we bought them at the “peak”.
- Restructuring debt to seek out the lower cost of financing
Never stop finding the lower cost of borrowing.
As we speak, we’re in the middle of refinancing 3 of our investment properties. We just completed one round of refinancing on these properties in early 2021. Now we’re on our way to refinance again.
Instead of paying a blended mortgage payment, line of credit allows us to pay interest only, lowering the monthly debt carrying cost.
If the plan goes well, we’re hoping to switch the B-lender financed properties to line of credit as well. Imagine, switching from a B-lender mortgage to a line of credit with interest only payment. We can easily increase our cash flow by $1,000 per property or more.
We’ll still use the excess cash flow to pay down our debt, but we get to choose the amount we pay.
Even if interest rates go up, we get the flexibility to pay less into our principal payment, maintaining the same level of cash outflow monthly.
Make sure you constantly look out for a lower cost of borrowing to minimize the biggest item in your rental operation.
- Take advantage of the dip
You have probably heard about the quote by Warren Buffet, “be fearful when others are greedy and be greedy when others are fearful.”
When there are multiple hike increases, we expect to see an adjustment in the real estate market. Coupling with the ban on foreign investors for the next two years, I’m definitely expecting to see a dip.
This can be the perfect opportunity for capable investors to enter the market, take advantage of the downturn.
Remember the market downturn in March 2020 when nobody was buying properties? Well, this is your chance to score some hidden gems while you still can! As a realtor, you may even know exactly where to find them.
- Relax, rates will remain low… for a very long time
From the narrative on Statistics Canada’s website regarding 2020’s government debt level, “Our debt charges (the Government of Canada interest expense) remain low despite record debt levels. This is a result of increasing money supply, encouraging lending and investment and keeping short-term interest rates close to zero. This allows our government to finance the unprecedented deficits generated during the pandemic at low cost and to refinance maturing debt at lower rates.”
The flip side of this narrative is that when the Bank of Canada increases its prime rate, coupled with the stop of quantitative easing, means that the government will have to finance their future deficit and refinance their current debt at higher rates.
Remember, when the BOC increases its prime rate, it’s also increasing the interest expense that the Government of Canada is paying.
The Government of Canada has about $2,852 billion of total liabilities as of 2020. A rate change is going to increase the cost of financing, not just for us, but for our government as well.
Yes, the rate is likely going to increase again.
No, Bank of Canada won’t have a substantial increase like back to 23% in the 1980s, or even back to 8% in the 1990s…or else our governments will go broke.
Hope this article helped you understand how the Bank Of Canada’s rising interest rate can help you as a realtor and investor!
Until next time,
Cherry Chan, CPA, CA
Your Real Estate Agent Accountant