INTEREST RATES: Beware rising rates and don't overextend

In recent weeks, the Finance Department and the Bank of Canada have both issued warnings to consumers about not getting overextended borrowing at today's historically low interest rates. In several recent blogs and columns, I've made a similar point aimed at bond investors: that it's only a matter of time before rates start rising again.

Certainly I'd rather be on the interest-receiving end of the equation than the interest-paying end. The way things are rigged, savers are punished by receiving almost nothing in interest, while borrowers are tempted to go into hock because of the same low rates.

As noted in a cautionary release today from BMO Financial Group, home sales in Canada have surged 76% from their January lows. By November, prices of existing homes were 19% higher than they were a year ago, which is the second fastest price surge in 20 years. Plenty of renters are thinking of jumping in while rates are still low, perhaps worried that, as so often happens with housing, prices will jump even more while they sit on the sidelines and save for a downpayment.

BMO's economists are predicting that interest rates will indeed rise, likely in the second half of 2010. "We expect the Bank of Canada's overnight rate target to climb from 0.25% beginning in July 2010, to 4.25% in mid-2012. In turn, consumers can also expect mortgage rates to increase," says BMO Capital Markets senior economist Sal Guatieri. "While today's ultra-low borrowing costs represent a unique opportunity to purchase a property, home buyers need to proceed with caution and keep in mind that renewal rates will likely be substantially higher in coming years."

Beware dual temptation to minimize downpayment and extend amortization schedule.

BMO senior manager of mortgages Jane Yuen warns that stretching budget limits by choosing the maximum amortization period and minimum downpayment could leave new homeowners with little wiggle room if they later are confronted with unexpected financial emergencies. "A meaningful downpayment and shortening your amortization by making extra payments on your mortgage will save you tens of thousands of dollars in interest costs."

While the best mortgage is no mortgage at all, the next best thing is one that's paid off in a matter of years, not decades. Below are some other tips from BMO on this topic. I don't disagree with any of these tips so what follows in the next few paragraphs are BMO's own words. When you get to the bit on variable versus fixed, pay close attention.

Consider a shorter amortization:

- The shorter the life of the mortgage, the less you pay in interest.

Make a larger downpayment:

- If you can provide a bigger downpayment, it's a significant way of helping you pay less interest over the life of your mortgage.

Make sure you can afford what you signed up for:

- Stress test your financial budget using a mortgage payment based on a higher interest rate: customers looking to renew a $250,000 mortgage currently priced at 2.25 per cent would see their monthly mortgage payment increase by $260/month if rates were to increase by two percentage points:

- Total housing costs (mortgage payments, property taxes, heating costs, etc.) should not consume more than one-third of household income.

Make pre-payments when you can:

- Pay weekly or bi-weekly instead of monthly.

- Take advantage of 20+20 prepayment privileges:

- Increase your mortgage payment (principal and interest) by up to 20 per cent over the current payment. This option can be exercised once each calendar year, at any time, without charge.

- Prepay up to 20 per cent of the original mortgage principal each calendar year. This option can be exercised in minimum amounts of $100 without charge, but some conditions may apply.

Always make sure you save for a rainy day:

- If you are up to your maximum in debt, you may not be well prepared for the leaky roof along the way.

Think carefully about fixed vs. variable:

- While variable rates mortgages have been a winning strategy over the long term, fixed rate mortgages (currently at historic lows) come with the peace of mind of being insulated against rate increases and knowing how much of your mortgage you will have paid down at the end of your term.

Yuen also warns that in today's heated market, prospective home buyers should try not to get locked into bidding wars that push mortgage payments outside their comfort zone. By getting a pre-approved mortgage, you should have a good idea of your budget constraints.

(prepared by Jonathan Chevreau/Financial Post/Vancouver Sun)