Interest Rates Arising – What Steps Should You Take?
David Christianson, CFP, R.F.P., TEP
Even before Bank of Canada Governor Mark Carney’s speech during the week of March 22nd, the writing had been on the wall that interest rates were going to have to rise this year and next, as the economies recover and inflation starts to heat up. Inflation is an almost inevitable consequence of the high amounts of government borrowing, stimulus spending and incredibly low interest rates. Currently, rates are at historic lows.
Today, we offer some reminders about what steps you should take in anticipation of rising rates.
IF YOU OWE MONEY
If you have variable rate debt, like lines of credit or a mortgage with a variable interest rate, immediately take stock of how your payments will change if interest rates go up, say, 2% and 4%.
For example, if you are currently paying 4% on a loan, become clear on the effect of a 6% and an 8% interest rate on that same loan. Depending on your loan structure, your payments might increase, or your amortization period might extend. Either way, get prepared now.
Just to give you perspective, from March 1994 to March 1995, the prime rate rose from roughly 5% to 9%. Ouch!
If such an increase would stretch your budget, you’ve got a problem that you need to address. Locking in for a long term right now is the obvious solution, but locking in means moving to a higher interest rate immediately. So how do you decide?
The key is how badly you could be hurt by the rising rates. If a 3% or 4% rise in your rate will be a serious problem for you, look now at either locking in, consolidating your debts, or developing a specific strategy for reducing your debts over the next six to twelve months. (That’s the ideal, and it might involve the novel idea of reducing spending.)
Some people will even look at breaking their current mortgage with less than a year to run, in order to lock in at today’s great rates.
The prime rate is currently 2.25%. Variable rate mortgages and loans are typically set at prime plus some percentage. As prime rises, so will the variable rate.
Currently, the best rate I can find on a variable mortgage is actually below prime. It’s hard to walk away from a rate like that to lock in longer term. However, lines of credit are more likely prime plus 1% to prime plus 4%.
Mortgage rates for six-month terms range from 3.5% to 4.6%, and one-year rates are 2.4% to 3.6%. Locking in for five years will cost you 3.6% to 5.4% and ten years can be had for 5.2% to 6.5%.
It is a relatively flat yield curve, which means that the lock-in premium is not as steep as at some times in the past. One school of thought is that the curve will flatten even more as short term rates rise, but that will have a lot to do with perception of the long term prospects for the economy.
You will have to decide if you favour stability and guarantees over lower rates. If you are willing to share the risk with the lending institution, they will give you a lower rate.
Be especially cautious about investment loans with variable rates, as often rising rates will hurt your investments at the same time.
INVESTMENTS CAUTIONS
On your investments, be cautious about owning bond funds or long-term bonds. The price of existing bonds goes down as interest rates rise, and the effect is more pronounced for longer term bonds.
Or, put more correctly, bond prices go down when the bond market decides that the prospects for economic expansion are good and the market starts to anticipate that interest rates will rise in the future. These price adjustments happen on a daily basis in the bond market, but will result in a sustained depreciation of bond prices if rates start to rise consistently over a period of time.
Owning bonds or GICs directly, where you have a personal maturity value guarantee, allows you to ignore the short term drops and hold to maturity.
In 1994, the average bond fund lost about 8% of its value. Your balanced funds also have a bond component.
I probably should apologize for introducing these complications, just as you were starting to open your investment statements again and enjoy them. But, hey, it’s my job!
Post questions and comments.
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David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can e-mail him at dchristianson@wellwest.ca or visit his website at www.davidchristianson.com.