Canada’s benchmark interest rate has been at 1 percent for more than two years and, as a result, a lot of Canadians have gotten pretty comfortable floating along on a cloud of cheap debt. Unfortunately, most economists agree that the air will go out of that cushy lifestyle - perhaps as early as this year - when interest rates rise. The problem is, most of us are just so darned comfy, we haven’t given much thought to what a rate increase could mean to our finances and financial well-being. In other words, many of us are living in a dream…and deliberately ignoring the fact that we may be drifting toward a serious financial wake-up call.
Are you living on the edge? Find out what areas of your financial life would be affected by an interest rate increase and what it could cost you.
House and home
According the Canadian Association of Mortgage Professionals’ 2012 consumer study, about 28 percent of homeowners have a variable-rate mortgage. And let’s just be clear: Those mortgages have provided huge savings in recent years. Remember, the interest rates on variable-rate mortgages are based on the prime rate, which may vary slightly from bank to bank, but is based on the benchmark rate set by the Bank of Canada. Because the benchmark rate has been so low, borrowers have enjoyed very low interest costs on their mortgages. Unfortunately, experts say the party may soon be over, and when the BOC does boost interest rates, the payments on variable-rate mortgages will rise too.
So how would that affect you? Well, let’s suppose that you have a mortgage with a $300,000 balance at a 3 percent variable interest rate and 25-year amortization. That equates to a monthly mortgage payment of $1,419. Now, suppose that your mortgage rate increased to 3.5 percent based on an increase in the prime rate. Now, your mortgage payment would be $1,497. For most people, that kind of increase isn’t too unmanageable. To be safe, however, most experts recommend that those who choose a variable-rate mortgage be prepared to pay up to 2 percent more per month, which would boost the monthly payment on that $300,000 mortgage to $1,744. That’s $325 more per month, a number that could prove to be a serious burden for cash-strapped borrowers.
Are you living on the edge?
Some variable-rate mortgages allow borrowers to lock in at a fixed interest rate. However, this option often includes a fee, and is likely to lock you in at a higher rate than the one you would have gotten had you opted for a fixed-rate mortgage in the first place. If you opt for a variable-rate mortgage, you have to understand that it’s a bit of a gamble. If you’re on a tight budget and paying a variable rate, you’re living on the edge.
Credit and debt
According to TransUnion, lines of credit account for about 42 percent of the $25,000 of non-mortgage debt the average Canadian carries. In many respects, a line of credit is a great way to borrow money. It’s flexible, it comes without fees and it’s much cheaper than a credit card. The risk here comes with the fact that lines of credit are variable-rate loans, which means that a borrower’s minimum payment can increase significantly if interest rates rise. This can hit people especially hard if that increase is combined with other forms of variable-rate debt.
So, let’s suppose that you’re carrying $10,000 on a line of credit at a 5 percent variable interest rate. The minimum payment on most lines of credit is 3 percent of the balance, which in this case would amount to $300. Now suppose that rate rises by 1 percent. In this case, your debt will rack up about $8 more per month in interest charges. That may not sound like much, but thanks to the power of compounding, even modest interest rate increases can make a large debt grow a lot faster, making it harder to pay off.
Are you living on the edge?
Tighter lending rules and softer profits for banks have pushed many lenders to increase the borrowing rates on lines of credit. In 2012, some banks raised the rates on these loans by upwards of 3 percent. Take a look at what you owe and what a rise in rates would do to your payments and balance. If it’s more than you can afford, you’re living on the edge.
Savings and investments
It’s easy to assume that a rise in interest rates is all bad news, but that’s only if you’re borrowing. If you’re saving and investing money instead, higher interest rates can actually be a good thing. Just as the benchmark rate influences the rate at which banks lend to consumers in the form of mortgages and other loans, it also affects the rate of interest the banks pay to depositors. This means that high interest savings accounts, GICs and cash-based investments all get a boost.
For example, the current rate of return on a 5-year GIC is around 2.25 percent. In 2008, that number was more like 4 percent. In the 1990s, rates were as high as 8 percent. These rates of return were influenced by the benchmark rate at the time. So, although consumers may have been hit hard by higher borrowing rates during those times, they also got to benefit from higher returns on guaranteed investments.
Are you living on the edge?
Savings help protect you from changes in the interest rate by providing a cushion to help cover higher debt repayment. In addition, the returns on savings accounts and guaranteed-return investments like GICs rise along with interest rates, helping to mitigate the risk of these rises to your overall financial stability. If you don’t have a savings account or investments, you’re living on the edge.
Stepping back from the edge
Interest rate fluctuations are a fact of financial life. The ultra-low interest rates we’ve enjoyed over the past few years have made it easy to live on borrowed money, but all that really amounts to is living a dream. When interest rates rise – and eventually they will – it’ll be time to tighten our belts, step back from the edge and wake up to reality.