Low interest rates have ruled personal finance for more than a dozen years, and those who paid attention were bigtime winners. But that chapter in the financial history of Canada is over. As in, over. Toast. Finito.
To counter inflation, interest rates are rising at an alarming pace. As a result, we need a rethink on some rules of personal finance that use low rates as a base assumption:
Investing is a better use of your money than paying down debt
The Canadian stock market was up about 30 per cent 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 per cent. If you had some spare cash, using it to invest was by far the more rewarding choice over paying down debt.
It was never a bad move to pay down your borrowings – the results are guaranteed to benefit you in reduced interest and a sped up timeline for becoming debt-free. But investing was the choice that produced gains you could wrap your hands around.
We had a great run for stocks – hope you enjoyed it. In the months ahead, expect extreme volatility driven by hopes of postpandemic economic renewal butting up against inflation, interest rates and concern about a recession. We’ve seen just this sort of market environment last Friday and on Monday.
The risk of a bad investing outcome is rising and so are interest rates. The advantage of debt paydown over investing grows day by day.
All that matters is the monthly payment
Whether you’re buying houses or vehicles, the affordability measure preferred by most people is the dollar amount of the monthly payment. When interest rates are stable, this approach works well enough. But as we’re seeing in 2022, payments can get uncomfortable in a hurry.
Rates are rising with an urgency, most borrowers have never seen or imagined. If you have a floating-rate debt like a line of credit, floating rate loan or adjustable-rate mortgage, your cost of borrowing is at risk of increasing on each Bank of Canada rate-setting date. The next date the bank could raise rates is July 13. After that, there’s Sept. 7, Oct. 26 and Dec. 7.
Protect yourself against rising debt payments by focusing on more than just how the monthly payment fits your budget at the time of borrowing. Two things to consider: How much is my income likely to rise during the term of my loan? And what percentage of household income does my total debt account for?
Mortgage lenders let you borrow to the point where your payments for all debts combined account for a maximum 44 per cent of your gross income. Try for 35 per cent and give yourself some breathing room.
HELOCs are a no-sweat way to borrow
One of the many appealing things about a home equity line of credit is that you can make a minimum payment of interest only every month. Gives you flexibility, right? Renovate the kitchen today, pay the bill whenever.
A competitive HELOC rate is your lender’s prime rate plus a markup of 0.5 of a percentage point. This year’s prime rate increases have bumped up the cost of this HELOC to 4.2 per cent from 2.95 per cent. Expected rate hikes in the next six months could increase that rate to nearly 6 per cent.
On a $50,000 HELOC balance, an increase in rates to 6 per cent from 2.95 per cent would mean an extra $127 a month. That’s a big spending bump for a household already paying more for gas, groceries and lots more.
HELOCs still have a role for short-term borrowing, but they’re more of a handful than they were a year ago.
Inflation means you lose money in savings and GICs
The inflation rate is 6.8 per cent, while savings accounts offer 1.5 to 2.4 per cent at best and rates on guaranteed investment certificates top out around 4.5 per cent for five years. You can’t avoid a negative real rate of return if you park money safely.
If someone mentions this to you, just ask where they’re finding inflation-beating returns these days. Stocks? The S&P/TSX Composite Index was down 3.3 per cent for the year to June 10, and the S&P 500 was down about 18 per cent. Bonds? Down about 13 per cent this year. Bitcoin? Down about 50 per cent. A positive return on safe money that turns negative after considering inflation is not the worst thing these days.
The Globe and Mail
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