What happens when interest rates rise?
The short answer is a lot can happen. Interest rates are the main tool the Bank of Canada has to keep inflation in check and the economy humming along. And they have consequences for your household budget, too.
For the economy, rising interest rates are meant to slow down the rising cost of living—things we have all been talking about lately: rising fuel costs, grocery bills and the housing market. On a personal level, higher interest rates can increase your monthly debt payments and make it harder to get by.
BDO's recent Affordability Index found that 43 per cent of Canadians are sacrificing essentials, like clothing, food and utilities right now. Even small increases to their mortgage or line of credit payments can spell trouble.
To prepare for rising interest rates, it’s important to understand how interest rates work, how rate hikes may affect your debt and what you can do to adjust your finances accordingly.
Interest rates are important for two main activities: saving money and borrowing money.
For savers, the interest rate is the amount you earn at a bank or a credit union for depositing money into a savings account. High-interest savings accounts, guaranteed investment certificates (GICs) and bonds are all ways to increase your savings through interest earned. For savers, rising interest rates are a good thing.
For borrowers, an interest rate is the amount a lender charges you to take out a loan. When you borrow money from a bank to buy a car or a house, interest is added on to the principal amount. For many borrowers, rising interest rates make their debt payments harder to afford.
In Canada, interest rates were at an all-time low until recently. For many analysts, these rock-bottom rates sparked inflation and an increase in living costs.
The Bank of Canada (BoC), who sets the rate at which financial institutions and their customers can borrow money, are responsible for raising interest rates. Due to economic stressors, like COVID-19, the BoC lowered their key lending rate to ensure consumers and businesses continue to spend and to stimulate the economy. The economy has now recovered to pre-pandemic levels and presents new challenges. Higher interest rates are meant to help encourage Canadians to borrow less, which will cool inflation and slow the increase in living costs. But it also means higher borrowing costs.
The BoC has raised rates multiple times in the past 12 months and another hike in the summer is likely as well. Here’s how to find out if your debt payments will be impacted.
The debts to worry about are variable-rate debts or debts whose interest rate fluctuates over time.
Do you have debt whose interest rate is pegged to a lender’s prime rate? When you see “prime plus two per cent,” this means you have variable-rate debt. Financial institutions change their prime lending rate based on the overnight rate set by the Bank of Canada.
Fixed-rate debt like most credit cards and fixed-rate mortgages won’t be impacted by rising interest rates.
Here are some examples of variable-rate debt.
Many homebuyers flock to variable-rate mortgages because they offer the lowest interest rates you can find on the market. But they come with added risks. No one knows exactly how high interest rates will climb. And variable-rate mortgages will be impacted the most as interest rates rise.
You can calculate how much your mortgage will be using this mortgage calculator. Rate increases happen incrementally, usually around 0.25 per cent each time. For example, if your current monthly payment is $2,000 at a variable rate of 4.5 per cent, your mortgage payment will increase to approximately $2,358 after four interest rate hikes of 0.25 per cent each.
Mortgage debt is the most likely to cause pain when interest rates increase. If you need help managing this type of debt, a Licensed Insolvency Trustee can explain your debt relief options.
Lines of credit and HELOCs are another type of variable-rate debt. In particular, HELOCs are the biggest contributor to personal debt loads in Canada are impacted by rises in interest rate. This means an increase in both your interest rate and your minimum monthly payment. The impact on your budget may not sound like much if you have one type of variable-rate debt, but it can add up quickly when you have a mortgage and multiple lines of credit.
Student loans from a financial institution are usually variable-rate debt and will cost you more as interest rates go up.
Ever heard of the avalanche method? Start with the debt with the highest interest rate and pay it down first. Then move on to the next and repeat. If you can eliminate or at least reduce the amount you owe on payday loan, retail or bank credit cards, this will create room in your budget to absorb any additional costs caused by a rise in interest rates. Remember that as interest rates rise, the proportion of interest rate charges on a payday loan or a credit card will still likely be higher than a mortgage or line of credit. It’s why eliminating high-interest rate debt first is a winning strategy.
The cost of living is at an all-time high. And even though interest rates are meant to cool inflation, we all see higher grocery and fuel costs right now. The goal with all budgeting is to ensure that you're bringing in more money than you're spending. Do all you can to avoid taking on any new debt, when you have debt the last thing you want is more debt. If you need help getting started, try our budgeting worksheet.
If you find that you're falling behind, or you're getting close to the edge of falling behind, it's time to act. There are ways big and small to save money. Maybe buy some of your weekly grocery shop at the dollar store, cancel a subscription you don't use much, delay any major purchases, scale back your summer vacation plans and do a series of more cost effective of day trips instead. Doing a few simple changes can save a large chunk of change both short and long-term.
If you're able to, (and we know not everyone is), take on more work. A gig job or something part-time for a few extra hours a week can make a huge difference to your household finances.
We know that people across the country are struggling with their finances right now. Know that if you're behind on bills and can't catch up there are options. BDO's newest Affordability Index found that a majority of Canadians don't know the full extent of the debt relief options that are available. One of these is a consumer proposal, which can reduce your debt load by up to 80 per cent. It also allows you to keep your house and assets as well and can be personalized to meet your needs.
Only a Licensed Insolvency Trustee can file a consumer proposal on your behalf. It's possible that you don't need a consumer proposal though. In that case a Licensed Insolvency Trustee can review your financial situation and recommend the debt relief option that works best for you.
The first consultation with one of BDO's Trustee's is completely free.