February 20, 2020

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Small hike, big deal?

First interest rate increase in years doesn't require drastic action... yet

Hey there, time traveller!
This article was published 22/7/2017 (943 days ago), so information in it may no longer be current.

If your financial situation makes you feel like a hamster on the wheel, get used to running faster.

That’s because the much-fretted over, and often talked about, interest rate hike actually happened. The Bank of Canada raised its overnight lending rate from 0.5 per cent to 0.75 per cent earlier this month.

That may not sound like much. For most people, that is indeed true.

"This rate increase won’t likely break anyone," says certified financial planner Cory Papineau with Assiniboine Credit Union in Winnipeg.

Most can afford a slightly higher interest payment on their line of credit or variable rate mortgage — the two types of debt most affected by central bank interest rate movements. (Mind you the five-year, fixed rate did increase slightly in advance of the hike by about 15 basis points, according to data from the Canadian Association of Accredited Mortgage Professionals.)

In the broadest sense, the hike is actually a good sign. The central bank wouldn’t raise rates if it did not believe the economy could handle it. The second takeaway is it’s probably reversing a trend that began in the early 1980s. Interest rates have for the most part been falling for more than 30 years — often referred to as one of the longest bull-runs in history. Bond holders have been rewarded over this time as falling rates increase the value of their bond holdings.

Another plus of falling rates has been the fact it’s become cheaper to borrow.

But falling rates have cut the other way, too. Low interest rates have devalued money and increased the value of hard assets such as real estate. So today, for example, we must borrow more to buy less property. As a lender, falling rates might have increased the dollar value of existing bond holdings, resulting in capital gains if you sell them. But the fixed income yields — interest earnings — have fallen steadily for years, making it much more difficult to earn steady money. So funding retirement is more difficult than ever because interest income has been progressively shrinking.

Now, it appears we’re headed in the opposite direction.

So what does this mean for the average person? Not much, yet — even if you’re a borrower, Papineau says.

For example, on $100,000, the recent hike would increase your monthly payment by $21, he points out.

Still large debts with variable rates could become significantly more costly in a year’s time if, for example, we see two more hikes.

A $400,000 mortgage debt with a variable rate could involve $250 more in monthly payments, for instance. That’s a grocery bill for many families.

With this in mind, Papineau recommends if you’re carrying debt, you should start paying it down, aggressively, sooner than later.

Sure existing credit-card debt, car loans and fixed-rate mortgages are mostly unaffected by central bank hikes. But it should go without saying the existing credit-card debt is troublesome regardless of the interest-rate climate because its interest charges are generally much higher.

But for individuals with home-equity lines of credit and other variable rate vehicles, even small increases could make life more challenging, says Bradley Milne, an insolvency trustee with MNP in Winnipeg.

"Chipping away at the principal just becomes that much more difficult," he says.

"And if you’ve already been living paycheque to paycheque, any hike is going to likely affect your budget."

To that end, he believes a lot of Canadians are already stretched. A recent survey sponsored by MNP seems to indicate his hunch is on the money. It found more than seven in 10 surveyed would be challenged to absorb a one per cent rate hike. And roughly one in four would struggle if their monthly debt payment increased by $130.

"Those results mirror what I see on a day-to-day basis," he says.

His suggestion to people fretting over the recent increase and future hikes is start budgeting so they can find cash to divert to debt repayment.

Still the president and CEO of Lowestrates.ca, an online source for shopping for mortgages and other loans, says individuals should think twice before running out to their lender to lock into a fixed-rate mortgage — common advice in a rising rate environment.

"We believe that’s wrong," Justin Thouin says. "If you look at the past 20 years, consumers have always done better being in a variable-rate mortgage."

One could argue — and maybe rightly so — that history will not repeat itself. Rates may well trend upward for some time and a fixed-rate mortgage could provide some shelter.

But Thouin says we need perspective.

"Even if the Bank of Canada raises the rate by half a per cent, you’re still better off being in a variable rate than a fixed rate," he says, adding fixed-rate mortgages are often only more advantageous for people on very tight budgets who can’t handle higher payments.

"But if you’re that tight, then you’re probably borrowing too much money in the first place."

Fixed or variable, the main message is to deleverage. Only borrow when absolutely necessary — like if your furnace breaks down in the middle of winter. But mining the home equity to fund a hot winter vacation is even more of a poor choice today than it was a few weeks ago. Sure these vacations are wonderful, but borrowing to fund them will likely hurt much more long-term.

If you’re on the other side of the coin — a lender — the most recent rate hike and future ones may hurt, too, at first. Your existing fixed income holdings (the bonds, not GICs) are negatively affected by rate increases. But more long term, the yields will improve providing more, reliable income.

Still caution is the name of the game.

"My first piece of advice on the investment front is, do nothing," Papineau says. "There are always changes happening in the market and many of these changes are already priced in to the value of the bond and stock market before retail investors even hear that something could be happening."

Stick with short-term maturity fixed income.

Don’t be tempted to invest in higher yielding, longer-term bonds.

"We may not see another hike for quite awhile," Papineau says.

"And there is always the potential for a drop should the economy falter again."


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