Low interest rates have ruled personal finances for more than a dozen years, and those who paid attention were big winners. But that chapter in Canada’s financial history is over. As in, done. Toast. Finito.
To counter inflation, interest rates are rising at an alarming rate. As a result, we need to rethink some personal finance rules that use low rates as a base assumption:
Investing is a better use of your money than paying off debt
The Canadian stock market has risen about 30% in total over the past two years, while the interest rate on money borrowed on a mortgage or home equity line of credit was easily below 3.5 %. If you had extra money, using it to invest was by far the more rewarding choice than paying off debt.
Paying off your loans has never been a bad decision – the results are guaranteed to benefit you with reduced interest and an accelerated time to become debt free. But investing was the choice that produced gains you could build on.
We had a great stock run – hope you enjoyed it. In the months ahead, expect extreme volatility fueled by hopes of post-pandemic economic revival colliding with inflation, rising interest rates and fears of a recession. We saw this kind of market environment last Friday and last Monday.
The risk of a bad investment result increases, as do interest rates. The advantage of debt repayment over investment is increasing day by day.
Only the monthly payment counts
Whether you’re buying homes or vehicles, most people’s preferred measure of affordability is the dollar amount of the monthly payment. When interest rates are stable, this approach works quite well. But as we see in 2022, payments can get uncomfortable in the rush.
Rates are rising with an urgency most borrowers have never seen or imagined. If you have variable rate debt such as a line of credit, variable rate loan or variable rate mortgage, your cost of borrowing may increase with each Bank of Canada rate setting date. The next date the bank could raise rates is July 13. After that, there is September 7, October 26, and December 7.
Protect yourself against rising debt payments by focusing on more than how the monthly payment fits your budget at the time of borrowing. Two things to consider: How much is my income likely to increase over the life of my loan? And what percentage of household income does my total debt represent?
Mortgage lenders allow you to borrow up to the point where your payments for all debts combined are a maximum of 44% of your gross income. Try 35% and give yourself a break.
HELOCs are an easy way to borrow
One of the many benefits of a home equity line of credit is that you can only make a minimum interest payment each month. Gives you flexibility, right? Renovate the kitchen today, pay the bill anytime.
A competitive HELOC rate is your lender’s prime rate plus a 0.5 percentage point mark-up. This year’s prime rate increases pushed the cost of this HELOC up to 4.2% from 2.95%. Expected rate hikes over the next six months could push this rate to close to 6%.
On a HELOC balance of $50,000, an increase in rates from 2.95% to 6% would mean $127 more per month. That’s a big expense increase for a household that already pays more for gas, groceries and more.
HELOCs still have a role to play for short-term borrowing, but they are rarer than a year ago.
Inflation means you lose money in savings and GICs
The inflation rate is 6.8%, while savings accounts offer 1.5-2.4% at best and rates on guaranteed investment certificates cap at around 4.5% for five years. You cannot avoid a negative real rate of return if you park your money securely.
If anyone tells you about it, just ask them where they find inflation-beating returns these days. Actions ? The S&P/TSX Composite Index was down 3.3% for the year to June 10, and the S&P 500 was down about 18%. Obligations ? Down about 13% this year. Bitcoin? Down about 50 percent. A positive return on safe money that turns negative after factoring in inflation isn’t the worst thing these days.
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