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.
For the 47 per cent of Canadians who are living paycheque-to-paycheque, 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 are at an all-time low. For many analysts, these rock-bottom rates have 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 expected 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. [GC1]
Borrowers can expect multiple rate hikes starting as early as March. 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 when 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 1.5 per cent, your mortgage payment will increase to approximately $2,241 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 and will be impacted by the forthcoming interest rate hikes. You will see 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.
The interest on many federal student loans is frozen until March 31, 2023, however, 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 even if 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, you will likely see higher interest charges and higher grocery and fuel costs at the same time. In this climate, it’s important to keep track of what’s coming in and what’s going out so you can make the right adjustments. If one area becomes more expensive, trim your expenses elsewhere. If you need help getting started, try our budgeting worksheet.
For current mortgage holders, interest rates are much higher than they were a year ago, but they are still historically low. If your mortgage is up for renewal, start the process now. Interest rates are likely to increase further. Are you looking to buy a home? Start the pre-approval process so you can lock in a lower rate for up to 120 days. If you have high-interest debt, like credit cards, and have yet to take advantage of lower interest rates, it’s always a good time to consider debt consolidation to save money on interest.
Are you unsure how to go about tackling your debt? A Licensed Insolvency Trustee is a great resource for learning about your debt relief options. If you’re unable to consolidate your debt and make improvements to your budget, an LIT can explain all your options free of charge. You may qualify for a consumer proposal which can reduce your debt load by up to 80 per cent.
Are you unsure about how to prepare your finances for higher interest charges? Book a free consultation with a Licensed Insolvency Trustee to learn about your options.
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