Why you should care about rising interest rates

EPISODE SUMMARY

Interest rates are going up and in this episode, Jordan Arndt and Evan discuss what that means for you and why you should care.

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TOPICS IN THIS EPISODE

1. Setting the stage - interest rates are rising 
2. What happens when interest rates rise 
3. How does that affect you 
4. How does that impact your investment portfolio 
5. Should you care about rising rates? 

RESOURCES MENTIONED

Bank of Canada - Policy Interest Rate


OTHER EPISODES

37. Dips, Corrections and Crashes

39. Why do Prices Keep Going Up 

47. Guide to Recessions and Bear Markets


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Transcript

Evan Neufeld: Hello and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. Today we are talking about interest rates and what that means for you, your investment life and your debt.

Well, after a brief hiatus, I'm joined again by my co-host and colleague here at Enns & Baxter Wealth Management, Jordan Arndt. Thanks for coming back. 

Jordan Arndt: Thanks Evan. Thanks for having me back. 

Evan Neufeld: All right. So as we mentioned in the intro there, we're going to be talking about interest rates. The main reason that this is coming up today is because well you're going to be listening to this afterwards, but as we record here, just this week the Bank of Canada raised interest rates by 0.5%.

That's the biggest one time increase in I think it was like 20 years. So this is a pretty big deal. So we wanted to have a conversation today about what this actually means for you.  So Jordan start us off. What is one of the main things that happens when interest rates rise? 

Jordan Arndt: I think one of the main things that happened is you will see that trickle down to the debt that you might have. So perhaps you have a mortgage, perhaps you have a line of credit. As the Bank of Canada raises their target interest rates, you might see then your bank perhaps RBC or whoever it is raise their prime rate in accordance.  Typically, I think that happens a day later or a couple of days later, there's a bit of a lag time, but not very long. So you might see that on your personal debt that you have. 

Evan Neufeld: Yeah. So the prime rate is just the general rate that banks will lend out money to you and I, or specifically people with spectacularly good credit. Generally your interest rate will be multiple to or in addition to prime, so often you'll see things like prime plus one, prime plus three, five, whatever it is. But prime is just kind of that base rate. And the base rate of prime is generally determined based on the prevailing interest rates that the Bank of Canada sets, this is called the overnight rate.  We're not going to get into that because the mechanics of it are a little bit convoluted and not really worth explaining here on the podcast necessarily. But when the Bank of Canada increases interest rates, generally banks will increase their prime rate, which means that if you have debt, particularly on a variable rate situation, your interest rate will increase along with it.  So trying to get a couple of examples there, mortgages, home equity lines of credit. Sometimes we call those a HELOC as an acronym there. Give me an example here. What does this mean for someone who has a typical balance on a HELOC? 

Jordan Arndt: So let's say with a HELOC, let's say it's a variable rate tied to prime. For example, again, let's say you have a hundred thousand dollar balance on that HELOC.  A 0.5% increase, which again is what the target rate just changed by, raises your annual interest payments by $500, which is about $42 a month. 

Evan Neufeld: Yeah, so it was not huge necessarily yet. This isn’t hopefully going to mean the difference between you keeping the roof over your head or not. But 42 bucks a month. That's a lot, I'm sure you've had or canceled subscriptions to video streaming things or whatever that it has been significantly less.

Jordan Arndt: Yeah. It's significant. And not that we want to get too much into speculation, but it sure seems that the prevailing news is this isn't the last rate increase for the year.  So it was $42 a month this time and you know, what will happen in the future? I guess, let me just be cognizant though. 

Evan Neufeld: Right. The fun has just begun unfortunately. So now variable rate mortgages, mortgage calculations are little bit different in there's a little bit more competition there, and there's a bit more forecasting that goes into the rate.

So mortgage rates aren't necessarily tied to prime directly. So if you have a variable rate mortgage, yes, you can hang your hat on the fact that your interest is going to go up. But with most variable rate mortgages, not all of them, but most of them are actually set up to just change your amortization, not your monthly payment.  So what this means is that every payment you make, more of it will now go to interest instead of principle, which is the original amount that you borrowed. So in a variable rate mortgage, many people will just have to pay longer to account for it, but their monthly cashflow won't necessarily be affected by it.

So that's okay. It won't necessarily change how you live month to month, but if we're looking year to year on a 25-year mortgage dragging out those payments can be a bit of a pain. 

Jordan Arndt: I think you make a good point, Evan. It's probably prudent to understand that the terms of your mortgage and exactly how that's structured, just so you can understand. Like maybe the rates are going up and it doesn't seem like it's affecting you because the mortgage payment out of your bank account was the exact same it was last month and it was for however long before. But be aware if that is extending your amortization period, it will take you longer to pay that off.

Evan Neufeld: Okay. So what about a fixed rate mortgage? Or a fixed rate loan or something like that. Generally speaking, those aren't going to be affected because that's the benefit of the fixed rate, meaning, you know what you're going to pay till the end of your specified term.  So if you've got a mortgage that's locked in, I call it 2.8% until the end of your five-year term is up or whatever length of term you have. You know what you're going to pay and you know how much it's going to go to interest and how much is going to go to principal, that is fixed. However, what happens when you have to renew?

Jordan Arndt: Yeah. Then you're  at the mercy, I guess, of whatever the lending rate is at that time, I think the term length in that case, or how much longer you have until your term is expired is kind of the important piece of that. Maybe you just renewed and you have five years until that renewal comes up again, that's probably different than if your renewal is six months from now and just the way that interest rates are going because you will be paying your new borrowing cost will be at that new rate.

Evan Neufeld: Yeah. It could potentially leapfrog your expectations. So if you've been paying 2.8% on a mortgage for a while, and your terms about to come due, you might be in for a rude awakening, unfortunately.

What about new debt? So if you are taking out a new loan of some type. Generally speaking, those are going to be much higher as well. So whether it's variable or fixed, because interest rates have gone up. Your new debt will also go up accordingly. So this comes back to the prime rate again.  So when you take out a new loan, oftentimes it'll be reflective of the prime rate. Jordan, can you put in context for me here? So prime is what, 3.2% as we're recording this now.

Jordan Arndt: 3.2% here today. Yeah. It's interesting to look at that in the context of history. You know, sometimes maybe we say historical too often, but these have been historically low rates as of a very recent time.

So prime rate has been, I think it was as low as 2.45 here, kind of over the last year and in 2021. Historically though, that's incredibly low. Let's just go extreme here in the early 1980s prime rate was 22.75%. 

Evan Neufeld: That's like credit card rates or worse.

Jordan Arndt: Crazy, significantly higher than 2.45 that's for sure. All through the eighties, it's going up and down, but it's anywhere between 10 and 14%. And that's kind of slowly trended downwards from there through the nineties, it was, you know, into your eight, 7%. And then in you know, ever since 2008 and the global financial crisis rates have been quite a bit lower, kind of in the two and a quarter to about 4% max prime rates.  You know for us today this feels like it's going up and it's getting higher. And it, is, but broadly speaking, historically speaking, they're still quite low in the grand scheme of things. 

Evan Neufeld: So rates are quite low. But the problem is that Canadians and Americans and most developed countries have gotten used to cheap money or cheap borrowing. So those with high debt loads, personally or even companies too, this is going to get ugly potentially, right. 

Jordan Arndt: As a potential, it goes back. We were talking on a podcast a couple episodes ago about the price of housing and comparison to a household income. And, you know, 20, 30 years ago, that was about three times household incomes to the average Canadian home price.  And we're up closer to 6, 7, 8 times now. And so you think about that and okay sure interest rates are low, but as they go up and maybe your house is a little bit more extended borrowing costs compared to your household income. That puts a pinch, I think, on the typical consumer.

Evan Neufeld: And I always take a look at the compound interest conversation around this time. I don't like the term compound interest when it comes to investing because generally. Here's my beef, I'm going to go on a rant here. It's not interest people. Generally speaking the thing that compounds is your growth.  Generally that's capital gains. It could be a variety of different things, but interest is a specific payment. Interest is money received. Sometimes your investments will increase in value, but it's not actually a payment of money in your pocket. So I like when we're talking about investing, I like to use compound growth, but when we're talking about debt, Jordan’s laughing at me here.  When we're talking about debt, compound interest is the thing because that is what you are paying. You're making a specific payment, but now and rant over, compound interest works against you when you have debt. So the longer you leave it, or if you're just making minimum payments or things like that, these things can really, really start to pile up.

So this begs the question now of, should I invest or should I pay off debt? How does that conversation change now? 

Jordan Arndt: Yeah, it definitely shifts as interest rates and borrowing costs go up.  The argument of, wow, we should be investing instead because rates are so low. I think that starts to change a little bit that debt you hold is becoming increasingly expensive to maintain. Look at our previous example there of the, the home equity line of credit. This 0.5 increase on a hundred thousand dollars balance, $500 a year. It's real money. Let's take an example of a variable rate mortgage here, 400,000, nothing too crazy. This 0.5% increase. We'll add $2,000 to your annual interest costs.  So if rates continue to go up, kind of, as they're talking about, this has the potential to add thousands of dollars to your annual costs. We can then compare that to investment rate of returns by no means, you know, we're not speculating here or forecasting or giving any guarantees there, but recently borrowing costs have been so low that it was a prudent choice to invest rather than save depending on your situation.

And you know, it always depends. But as borrowing costs, rise. I think that argument maybe starts to change a little bit as your debt becomes more expensive. And you think about, okay, what rate of return can I reasonably expect to get from an invested portfolio? 

Evan Neufeld: For sure. And my point on this, I feel like we should do an episode or two or three on this topic, but when people ask me, should I pay off debt or invest?  I always say yes, because doing both is good for different reasons, right? Because it all depends on your timeline.  Say if your debt payment disappears? Well, then the value of that money that you put towards it largely, well the value is now known. Whereas if you're investing for the next 40 years. So each a dollar put in each place has a different lifetime value, especially if you're paying off debt on a depreciating asset, right? So the lifetime value of that dollar is going to be very, very different. Now when interest rates have gone up, the conversation changes a little bit more. So I still recommend a both and especially if your timeline is long for investing. But if there's a psychological component to the debt for you, which there is for most people.  I think it becomes a lot more compelling to say, maybe don't do all your eggs in the debt basket necessarily, but maybe do a little bit more because it'll feel that much better for you.

Jordan Arndt: I think too, we've said it before and I think it's worth saying it again. It depends on what your debt is. If this is credit card debt or something with 20% interest, pay it. It's not an either or in that case, you need to nip that that debt with significant interest rate costs nip that in the butt and get it out of there.  But yeah, when we're thinking about maybe student loans, car loans, and certainly mortgages or line of credits tied to prime rate I think you make some great points there. 

Evan Neufeld: Okay. So you asked me this question off air here and it's really good. Maybe we should have led with this, but what if you don't have any debt?  What if you've paid off your mortgage? What if you don't owe anything? Why do you care that interest rates have gone up? 

Jordan Arndt: Yeah. Good question. You know, maybe you're listening to this and maybe you don't have the mortgage anymore. Maybe you don't have any line of credits. And so there's all this talk of interest rates out there.  Do I really care? I think the one thing that jumps out to me immediately, and you know, this isn't an economical answer by any means, but there's a good chance your kids have debts or your parents have debt or your siblings have debt or whatever situation there is. So maybe this isn't as tangible and real for you, but it likely is for someone who is important in your life and it makes a difference. You know, maybe your kids are thinking about getting into their first home. But home prices are expensive and now borrowing costs are going up. How do we make this work? So maybe you aren't being directly affected by it, but you might be hearing about it through some other channels.  So I think that's one reason to care. How about you, if you don't have any debt, do you think I should care about this news about rising interest rates?

Evan Neufeld: The thing that I think about with this is if you don't have any any debt, I would assume that you're also an investor. So you own stocks or bonds or many other things too, but how are those effected by rising interest rates?  Well, the interesting thing with interest rates is that they generally directly impact bonds. We've talked about this a little bit on the podcast before, but as a refresher, as interest rates go up, the value of existing bonds goes down because say, for example, I own a bond that pays 2% a year. Now because interest rates have gone up, I could buy a new one from the market that pays 4%. If your buying a bond, you don't want my lousy 2% bond. You can just go to the market and buy a 4% one. So what I have to do now is discount my bond to make it interesting for people. So existing bond values decrease when interest rates go up. So if you're currently a conservative investor, so one that would own lots of bonds, this has not been a good time for conservative investors. 

Jordan Arndt: Rising interest rates are certainly a headwind for the bond market here.

Evan Neufeld: It is. It has not been good at all. So then with stocks, it's less of a direct connection, but more of an opportunity cost.  So say for example, I have a bunch of money that I want to put to work. And now I can buy a bond at 4 or 5, 6%, whatever the case may be. Whereas before I had to take on a bunch of risk in the equity markets to get that 5, 6, 7% that I was hoping for. So now if I can get a better return with less risk in the bond market, why would I go buy stock.  I'm being facetious here, but that's where certain stocks, particularly the ones that were very, very expensive. And as we've seen, those were kind of like the tech stocks and more speculative names like as some portfolio managers call them not for profit stocks because they're just more of a science project or an idea, or things like that, who wants to pay for that? No ones paying for future growth right now. So the things that have looked really good are the old boring businesses that pay dividends. We call them some of them value companies, things like that because there's a little bit less speculation baked into the price. So when interest rates go up, the really expensive stocks take a haircut.  And so, because a lot of the really expensive stocks were driving the returns of the broader market, the market as a whole kind of gets dragged down in this current environment.  You can't look back at history and say, every time interest rates have gone up, stocks have taken it on the chin. But generally speaking, that just makes sense because of the trade-off that now exists.  Right? So if there's a good alternative for my dollar, your dollars will start chasing the best alternatives at the lowest risk.  This is something that's a little bit more theoretical and takes more time to play out and things like that. But because of these fluctuations in values of both stocks and bonds, when interest rates go up you can bet that markets are going to be bumpy. That doesn't mean negative, but you're going to see some relatively large swings in both directions and you can also assume that equity markets are going to have lower average returns than they have in the past because debt is more expensive and alternatives are paying more. 

Jordan Arndt: So if you're telling me bonds are gonna suck and equities might suck, where am I putting my money today?

Evan Neufeld: Yeah, that's the million billion trillion dollar question, of course, but, okay let's just put this in the context of fixed income now. So now that bonds are paying a higher coupon rate, that's better. Like if you're wanting to make money with fixed income, at some point you have to have a higher coupon rate or else you're not going to be able to make any money. So this is a short-term pain, long-term gain situation with fixed income or bonds.  .So, yeah, eventually you have to have interest rates going up or else you'll never make money again from fixed income. Also when interest rates go down existing bond values go up 

Jordan Arndt: The opposite of what you started with is now true.

Evan Neufeld: Exactly. So now in a higher interest rate environment, fixed income, looking off into the medium distance future here, and depending on the duration of the bond, you know you can have 1, 2, 5, 10, 30, 40, 100 year bonds, depending on your duration.  These things are all relative. Bonds are a bit more of a math exercise because of all these things that you can calculate, but interest rates eventually have to be higher to have any hope of making money from fixed income investments. So I'm not calling this all a bad news story and then with equities, yeah those hyper speculative names that weren't making profits. Eventually, this is kind of what we call a correction because that's not correct necessarily if you're thinking or assuming that a company's stock price should be relative to earnings.  At some point you got to make money and the value of your ownership should be reflective of the profits that that company makes. So if people were overpaying for it before, and you've got more money to invest now, now you're just getting a better deal. There's lots of great companies out there that are now just cheaper than they were before.

So where are you going to put your money? If you're a long-term investor, you still have options, but you're just going to be riding a bit of a nasty wave in the meantime, while the market kind of sorts things out.  But that's the price of investing. You can't expect returns without any sort of risk. This is risk, right because it's the short term negative outcome for a potential long-term positive outcome. Yeah, stay the course is a really good option. Through this if you have cashflow, if you're employed, if you have money to invest, keep investing. This isn't a boogeyman stay out of this market.

This episode was hopefully trying to explain a little bit more about what you can expect in a rising interest rate environment. Let's recap. When interest rates go up, your debt gets more expensive, especially immediately if you have variable rate debt, like a home equity line of credit and a variable rate mortgage. If you have fixed debt, you're in luck because your payments will largely stay the same. But when you renew or if you take on new debt, be prepared to take that at a much higher rate than before.

Jordan Arndt: As we talked about investing versus saving the bait of where should we be putting our dollars that starts to shift as interest rates go up and your borrowing costs go up. So just kind of, as Evan mentioned, it's still maybe a good idea to do both depending on your timeline. But just, just think about your expected rate of returns and compare that to your borrowing cost. 

Evan Neufeld: Jordan this wasn't really a touchy-feely episode. Not a lot of  sunshine and rainbows. It's a cloudy day. Yeah, exactly. But you know, there's always this bit of a silver lining depending on where you want to look. There's never going to be a situation where they raise interest rates because the economy is doing poorly.  This is a situation where things look good. So they want to make sure that the economy doesn't run too hot and we try to get in front of inflation. You can go back and listen to our episode on inflation. So this isn't all bad news by any means. It's also not all good news either. This just is part of a healthy economy.  This isn't a problem that is trying to be solved necessarily. This is really common. But because everything is a moving target, the Bank of Canada reacts to what they're seeing. So we don't know where we're going to go from here, but we probably anticipate a few more interest rate hikes going forward.  And what we heard on the episode today should continue if that if that keeps happening. So anyways, thank you so much for taking the time to listen to our podcast today. If you do have questions or anything like that, feel free to shoot me an email. I've got my contact info in the show notes. If you're new and you haven't heard our podcast before and you thought it was interesting. Please share it with a friend. We'd love to spread the word about the podcast here. If you want to follow along, hit that follow button or subscribe on the podcast player of your choice, and hopefully we'll see you in a couple of weeks.

Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal, and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.