It's a crude analogy, but when interest rates are low, people behave a lot like they do at an all-you-can-eat buffet: pay a little and consume way too much. It's all in good fun until the party ends. When interest rates rise, people who've eaten through their bottom line and become bloated with debt are stuck with a heavy interest burden - one that can often sink their finances.
Although the Bank of Canada has maintained its ultra-low key lending rate at one percent since September 2010, the tide may soon be turning. In July, it predicted a gradual rise in this rate through 2014. That's bad news for big borrowers. According to a recent survey by the Canadian Institute of Chartered Accountants, 48 percent of Canadians said that a significant interest rate hike would make it difficult for them to keep up with their debt and mortgage payments.
The good news is there's still time to turn the tide on your overindulgence and whip those finances back into shape. Here are some of the things borrowers should be doing now...
1) Shed borrowing
Canadian household debt hit a record high in mid-2012, inching up to 152 percent of income, from 150 percent at the end of 2011, according to Statistics Canada. So, if you're like most Canadians you have debt, a lot of debt. But while it may be common, it isn't okay. Spending more than you earn is fun while it lasts, but it isn't a sustainable lifestyle. The potential outcomes — we're talking heavies like default, bankruptcy and foreclosure — aren't pretty either. If your personal financial ledger has more expenses than income, you're putting yourself at risk for all three, and that risk only gets bigger as interest rates rise.
Unfortunately, shedding that debt will be a lot harder than it was to pack it on. It'll mean hard work, sacrifice and setting new habits. Start by keeping a diary of your spending and looking for problem areas that are blowing up your budget. Then, start cutting out the things that aren't essential (sorry shoe collection, we're looking at you). What you save should go toward paying down your debt; the less you have, the better off you'll be when interest rates rise.
2) Pack on the savings
The CICA survey showed that 60 percent of Canadians save less than 10 percent of their monthly incomes. That means there's very little in the savings jar for emergencies, never mind retirement. Let's put it this way: if you're building up debt rather than savings, you're essentially walking a tight rope built on low interest rates, a decent job and the vain hope that nothing will ever change.
Unfortunately, the world, the economy and the twists and turns of life are totally unpredictable, and do not always work in your favour. Worst of all, you have absolutely no control over any of them.
What you can control is that tight rope. It can be narrow, treacherous and virtually impossible to cross safely, or it can be a little straighter, a little stronger and include a safety net in case things really go wrong. That safety net is your savings, and for many people, that's the only thing that stands between them and total financial ruin.
3) Shrink your rate
While debt repayment should be your ultimate goal, that isn't always possible in the short term. With that in mind, the other part of your interest rate strategy should involve cutting the interest rate on your current debt when and wherever possible. You can do this by consolidating higher interest loans like credit card debt into a loan with a lower rate. This rate will still rise along with interest rates, but making the switch now will at least provide a buffer and give you the chance to make a solid dent in your balance.
And what about your mortgage? As the big, hulking loan that tends to make up the bulk of our debt, what we pay in interest on our home is key. A rise in interest rates affects mortgage payments, most immediately for those with variable-rate mortgages. Most of these mortgages have an option to lock in at a fixed rate or switch to a different mortgage product. Talk to your bank or mortgage broker about the rules that apply to your mortgage, and start doing the math. And if you're counting on low interest rates in order to afford the payments on your current home, sorry to say but it's probably time to move.
Taking on debt is like putting on weight. Doing it is easy. Reversing it? Not so much. But while whipping your budget into shape takes discipline and hard work, it's never too late to take on the challenge. As Warren Buffett once famously said, it's only when the tide goes that you discover who's been swimming naked. Will you be the one left feeling vulnerable?
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