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Are you prepared for rising interest rates? Let’s face it we all knew that sooner or later interest rates were going rise. Central Banks are beginning to raise interest rates for the first time in years. The Fed has been on a roll increasing interest rates, the Bank of Canada has recently joined in with a 25 basis point hike (0.25%) and other European countries are also raising rates as well.
Already, I’m getting email promotions from Tangerine about earning 3.22% until September 30th on all new deposits! This is starting to remind me of the good ‘ol days when a high interest savings account (HISA) actually paid 4% interest! If you’re in your 20s, believe it or not, there was a time when you could earn 4% in a savings account!
Yes interest rates will rise, but it won’t be the end of the world…just the end of easy money.
How will Rising Interest Rates Affect You?
Well for starters, borrowing costs will increase across the board. If you have a line of credit or Home Equity Line of Credit (HELOC), the change will be immediate. Thinking about leasing a new car or truck? Chances are the financing costs won’t be 0% anymore. The biggest impact of rising interest rates will no doubt be felt in the housing market.
Mortgage Interest Rates Will Rise
The biggest impact of rising interest rates, of course, will be felt in the mortgage market. Housing is our largest expense, so any increase in the interest rate is bound to have a big impact on our monthly cash flow. When interest rates rise, fixed and variable rate mortgages will increase as well. So if you’re shopping for a home, expect to pay more. If you locked in at a super low rate, you’ll renew at a higher rate.
Higher mortgage interest rates should concern every homeowner because most of us qualified for a large mortgage based on record low interest rates.
Take a look at this basic example:
$300k mortgage, 25-year Amortization, 5-year fixed rate mortgage:
At 2.5% the monthly payment (principal and interest) is $1,343.90.
At 3.5% it becomes $1,497.81.
At 4% it’s $1,578.06.
The difference at 3.5% and 4% is about $150-$230 extra every month just in interest payments alone. Can you afford an extra couple of hundred bucks a month in added mortgage expenses? I can’t either. I don’t care how well banks claim to have stress tested borrowers. The couple who borrowed $500k (or more) to buy their dream home and then took out a HELOC for repairs, renovations, vacations, cars and “living” are going to be in trouble.
The bottom line here is that I think it’s time homeowners considered the different ways to pay off a mortgage faster so they can save themselves thousands of dollars in interest.
A Housing Correction that was Long Overdue
Perhaps the biggest impact of rising interest rates will be felt in Canada’s over-heated housing market. The reality is that, as rates rise, home values will decline to some degree.
Already a combination of government policies aimed at cooling the housing market and the rising interest rate environment are having an effect. Sales have dropped off dramatically in the Toronto area and prices are starting to come down. I believe this trend will continue.
If you sold your house back in March, congratulations you sold at the top of the market! If you won a crazy bidding war back in March, it’s gonna be one hell of a hangover! Adjusting to higher interest rates (ie. normal interest rates) will definitely cause some people serious pain.
The good news is that inflation isn’t exactly out of control, so I don’t expect interest rates to rise drastically. The most likely scenario will be that central banks raise rates slowly, to minimize the shock effect.
What Does All This Mean?
What all of this means is that we all need to confront the giant elephant in the room: our debt. Year after year I read reports that our debt to disposable income is growing and is now about 170%. That’s the highest that it’s ever been and should be cause for concern.
Alongside the reports about our ballooning debt levels, are reports that say it’s OK to have lots of debt because our assets (which in most cases means our homes) have also risen in value. This is dangerous thinking because, as we are now beginning to see, the value of our home is Falling but our Debt remains the same. This means that we are actually getting Poorer!
Let me explain with an example. One way to look at our financial well-being is to figure out our net worth. To calculate net worth, you just add up the value of all of your assets (ie. Investments and real estate), and subtract all of your debt (ie. Mortgage, credit cards, loans and lines of credit). The number you get is what your worth at a particular moment in time.
To grow your net worth you need to do 2 things: buy assets (ie. Things that will increase in value) and pay down debt (reduce our liabilities). For the past 10 years, too many people have focused on buying 1 kind of asset in particular (a house) and have paid less attention to paying off their debt.
Think about it, taking on huge amounts of debt to buy a house at inflated prices is a recipe for disaster in a rising interest rate environment. People are going to have to focus more on paying down debt plain and simple, particularly mortgage debt.
How I’m Preparing for Rising Interest Rates
I feel like I have a pretty big mortgage balance (about 375k) so my plan will be to keep making extra payments to kill the mortgage beast in less than 10 years. In fact, I will be stepping up the extra mortgage payments and investing less into my taxable stock account.
But in general, my investment approach will remain the same. I’m sticking to the same old plan. I will continue to buy my favorite dividend stocks, keep my retirement funds in low cost index funds and just sit back and relax.
I’m not even going to sell my short term bond funds! Why? The same reason that I didn’t sell my stocks in 2009, my gold in 2014 or my preferred share ETF in 2015. What goes down will eventually come back up. If you are diversified among different asset classes then it’s inevitable that at some point, one of those assets will go down in value. On the flip side, other assets will rise. Because no one really knows for sure what the future holds, it’s prudent to own a bit of everything: stocks, bonds, real estate, cash and gold. So the sell-off in bonds may mean that I’ll do some rebalancing and buy some bonds.
I think we all need to prepare, not panic about rising interest rates. That’s my plan anyway, what are you doing to prepare for rising interest rates?