Navigating the Maze of Rising Interest Rates and Debt: An Action Plan
In the financial landscape, rising interest rates and debt often go hand in hand. As the Bank of Canada continues to push its overnight rate target upward, many debt-ridden households are grappling with the dire consequences. How can you navigate this economic scenario? Here’s a comprehensive guide.
1. Understanding the Trend: Bank of Canada’s Rate Hikes
In its recent announcement on June 7, 2023, the Bank of Canada raised its target for the overnight rate, which now stands at 4.75%. This marks the ninth increase since March 2022 and reflects the Bank’s ongoing policy of quantitative tightening. For households with significant debts, these increases are eating into their budgets.
1.1 The Timeline of Rate Changes
To fully grasp the situation, let’s take a look at the timeline of rate changes since 2010:
May 31, 2010: 0.50% (Increase by 0.25)
July 19, 2010: 0.75% (Increase by 0.25)
September 7, 2010: 1% (Increase by 0.25)
January 20, 2015: 0.75% (Decrease by 0.25)
July 14, 2015: 0.50% (Decrease by 0.25)
…
June 7, 2023: 4.75% (Increase by 0.25)
2. The Impact of a 25-Basis Point Increase
Every time the Bank of Canada raises rates, banks and mortgage companies follow suit with increased mortgage rates. Let’s break down the impact of a 25-point increase on a small mortgage.
2.1 The Calculation
Imagine you have a $400,000 mortgage, amortized over 25 years, at 2.59%. Your monthly mortgage payment would be $1,810. If the rate jumps to 2.84%, your monthly payment would rise to $1,860—an extra $50 each month. If the rates go up five times as some economists predict, you could see a potential increase of $250 per month.
3. Historical Warnings: Predictions from the Past
The current situation should not come as a shock. As early as 2012, financial experts, during interviews on CBC Radio’s The Current, warned that low interest rates were making our debts seem ‘affordable’. They cautioned that a rise in interest rates could cause serious problems.
3.1 The Issue at Hand: Variable Rate Mortgages
For many years, Canadians found it beneficial to opt for variable rate mortgages (as opposed to fixed rate) because of the lower rates. But a variable rate can fluctuate—it can decrease or increase. Today, if you’re paying 3% on your variable rate mortgage, an increase by 1% would mean a significant spike in your monthly payments.
4. The Misconception: A 1% Increase is NOT 1%
This is where many people falter. A rise from 3% to 4% is not an increase of 1% in your payments. If your rent jumps from $300 to $400 per month, the rise is one third, or over 33%. The same applies to your mortgage interest rate—a 1% increase means over 33% rise in your payments.
5. The Ripple Effect: Impact on Different Loans
Higher interest rates affect various loans in different ways. Let’s delve into how different types of debts are influenced.
5.1 Mortgage Rate
For variable-rate or adjustable-rate mortgages, borrowing rates will increase. If you have a fixed-rate mortgage, your interest rate remains unchanged for the remainder of the term, although you’ll face higher rates on renewal.
5.2 Home Equity Loan (HELOC) or Line of Credit
For these, you will see an immediate increase in both your interest rate and monthly minimum payment.
5.3 Fixed-Term Loans
For term loans, your rate and monthly payment will remain unchanged even as interest rates rise.
5.4 Student Loans
Again, this depends on whether your student loan is a fixed-rate or variable-rate loan.
5.5 Credit Card Rate
For most fixed-rate, high interest, credit cards, rates do not typically change when interest rates rise. If you have a variable-rate card, however, your rate will increase.
6. Preparing for Rising Interest Rates: A Strategy
As the specter of rising interest rates looms, it’s crucial to strategize on how to deal with your debts before your borrowing costs spiral out of control.
6.1 Steps to Mitigate the Impact
Here are some steps you can take to reduce the impact of rising rates on your monthly budget:
- Make a list of your debts, their current interest rate, and type of loan.
- Prioritize paying off high-interest debt first.
- If you have no high-interest debts, focus on paying down variable rate debt next.
- Consider switching from a variable-rate to a fixed-rate mortgage or loan.
- Consider reducing the amortization period on your mortgage.
- If your debts are unmanageable, consider consulting a Licensed Insolvency Trustee.
While the future is unpredictable and we might see more interest rate hikes in the coming months, being prepared and considering all options will undoubtedly help you navigate the maze of rising interest rates and debt.
