Wednesday, 19 July 2017

Interest Rates are Up, Up and Away

What you Need to Know About Rising Interest Rates


You've likely already heard that the Bank of Canada raised their overnight interest rates last week from 0.5% to 0.75%, but do you really know what that means and how it affects you? For the last decade, we've been living with historically low rates in Canada, and this is the first time in 7 years that rates have gone up. If you're a millennial like me, you've lived almost your entire adult life under these conditions, but that doesn't mean it's the norm. Take a look at the graph below; it was way back in 2008 when rates plummeted after the financial meltdown. I was still in University way back then with little to no clue (or interest) in how that would affect me. 


Flash forward to 2017, and I have to say that I have benefitted quite substantially from the low-interest rate environment. We bought our house in 2010 and at that time signed up for a 5-year variable rate mortgage. At the time we thought rates would go up near the end of that term but that the initial savings would still set us ahead. When our renewal came up two years ago, rates were still low, but we thought there was no way we'd make it through another term without a raise and locked in after that drop in 2015. Honestly, the timing couldn't have been more perfect for us, and we've been able to put a big dent in our principal because of the low rates. Next renewal I don't think we'll be so lucky though!  


Now let's get into why the current conditions have set the stage for the rate hike by the Bank of Canada. 


What is the Bank of Canada? 
The Bank of Canada isn't like the normal bank you periodically visit to do your day-to-day banking (does anyone actually go to the bank anymore?). Instead, they're the bank for the government. Their primary goal is "to promote the economic and financial welfare of Canada" (Bank of Canada Act). That means they are in charge of maintaining low and stable inflation by controlling interest rates and the amount of money in circulation, designing and distributing those colourful plastic bills we're famous for, managing the debt and foreign exchange reserves for the government, and keeping the Canadian banking system safe and efficient. 

The bank controls interest rates by altering what is called the 'overnight rate'. Retail banks (BMO, TD, CIBC, etc.) are constantly borrowing money from each other, and the overnight rate is the one-day interest rate they are charged for such borrowing. In turn, the banks use that overnight rate to determine their 'prime rate', which is what they base your borrowing rates on. When the banks pay more, they pass on that additional cost to us consumers. 


Why Inflation Matters to You

Inflation is basically your buying power, and it's the reason that $1 was worth more in the past and will be worth less in the future. Remember when you were a kid and you'd go to the convenience store and buy a bag of 5 cent candies? Those little frogs, eggs, and coke bottles will now cost you 10 cents a pop! That's inflation. The Bank of Canada aims to keep inflation between 1 and 3 percent, thus ensuring that your dollar is going to maintain most of its value year over year. Crazy high inflation wreaks havoc on an economy and puts its citizens in a very tough spot because wage increases rarely keep pace. 

Interest Rates and Inflation

What exactly is the relationship between the two? Inflation decreases when interest rates go up, and it increases if rates go down. This is all tied back to consumer spending. When the government wants to stimulate the economy and therefore increase inflation, they will lower rates to encourage citizens to borrow and spend more. 

This is why the Bank of Canada recently raised rates, they think the economy has stabilized and are concerned that inflation will get too high. 


And Why Do You Care?

That quarter point increase might not sound like a lot but if you are carrying a substantial amount of consumer debt you might be in for an unfortunate surprise. This won't be the case if you have a fixed rate loan, your time will come when you're up for renewal again (like me). However, if you have a variable rate loan, then your payments will be going up right away. Variable rates are based on the prime rate, which has gone up from 2.7% to 2.95%, so you'll be paying an additional 0.25%. Variable mortgages aren't the only loans that will increase, many lines of credit or student loans are also based on the prime rate and would see payment increases. 

If this is the situation you find yourself in, then don't freak out. The first thing you need to do is figure out how much your payments are going to go up. Likely your bank will be sending you out a notification indicating exactly this, but if they haven't then reach out to them. Work those new numbers into your budget and see how it looks. You might have to make a few cuts in other categories to make up the shortfall, but that's the big perk about having a budget...there's always room to play around and make the numbers work. If you don't have a budget then you can sign up for my email list to get the template I use for free; better late than never ;) 


You also have the option to lock-in your mortgage to a fixed rate if you are really concerned about your ability to handle increasing payments. Rates have already gone up, and you'll likely have to pay a penalty for making a change part-way through your term but knowing your payments will remain consistent for the remainder of your contract might be worth it for your peace of mind. There seems to be a consensus that another rate hike or two will be on the way so if you're going this route then sooner is likely better.


The majority of credit cards and car loans are based on fixed rates, so it's unlikely you'll see any change in those (aka the high rates will remain high, so they're still not a good idea). 


What's the Good Side?

Canadian households have over $2 TRILLION in debt; that's over $55,000 for every single person. I can't even imagine what that number would be if you eliminated all the kids, retired people, and super savvy people who have no debt. While increased interest rates can have an immediate negative impact on those with variable debt, it can have a positive long-term effect on the overall debt levels of this country. It will also likely have a cooling impact on the out of control real estate markets in Toronto and Vancouver. The Canadian dollar also rose sharply after the rate increase announcement, but we'll have to wait and see if it can hold some of that momentum. Savers might also see a slight increase in the interest rate they earn on their savings account, this won't be substantial, but every penny counts right? 

Take the opportunity to use this as a reminder of the downside of debt. For a long time credit has been cheap and a lot of people have taken advantage of that. Even after this increase, rates are still low, but you can see how even a small rise can cause problems. 


In Conclusion

Interest rates have gone up, and there's a good chance more rate hikes will be coming. If you have variable rate loans, you will see your payments increase, but there are steps you can take to limit the impact including amending your budget and switching to a fixed rate contract. 

What you Need to Know About Rising Interest Rates

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