Managing Debt In A Period Of Increasing Interest Rates

Following nearly seven years of sustained, near historic low interest rates, Canadian debtholders were surprised this summer when the Bank of Canada introduced two back-to-back increases in less than three months. For a nation already over extended by record levels of debt, the moves put an unexpected dent in millions of budgets and have brought almost half the country within $150 of not being able to pay their bills each month. With some economists predicting the upward trend will continue, many are left wondering how they will keep up with the added interest costs.

To understand how rising interest rates will affect you and to avoid further financial difficulty, it is important to understand:

• How the Bank of Canada's overnight rate impacts the interest you pay on your debt
• How fixed and variable interest rates are affected by interest rate increases
• How different types of debts are affected by interest rate increases
• What you can do to plan for and offset increased interest costs

About the Bank of Canada Overnight Rate

The Bank of Canada's overnight (or policy) interest rate dictates the cost for major financial institutions to borrow and lend money amongst themselves. This price influences the interest rates banks charge their customers for the various loans, mortgages, credit cards and lines of credit.

Importantly, the policy rate does not directly translate to interest rates charged to the public by banks and other lenders. Rather, those are marginally higher to allow creditors to profit from their lending activities. For example, if the overnight rate is set at 1%, the prime rate charged by banks may by upwards of 3%.

Similarly, when the Bank of Canada increases its overnight rate, the increase for consumers will also be slightly higher. A 0.25% increase may actually mean a 0.35% jump for the public – or in the case of this summer's increases, the 0.50% reported in the media may actually be closer to a 0.70% hit to Canadians' pocketbooks.

Fixed or Variable Rate?

When interest rates go up, you may or may not see the immediate consequences.

If you are carrying fixed rates on your mortgage, loans or lines of credit, your interest rate will most likely remain the same for the duration of your fixed term. However, once it comes time to renew, your new rate will be influenced by the current overnight rate at that time, which may be higher or lower than what was agreed to at the outset of your previous term.

If you are carrying variable rates on any debt, your interest rate will increase immediately and you will most likely see the difference on the following bill.

How Interest Rate Increases Will Affect Your Debt

When and how significantly the effects of increased interest rates are felt will depend on several factors – including the type of debt you have (fixed or variable), how many debts you own, how much debt you are carrying and if (and how much) you are currently contributing to the principal value.

Mortgages – Mortgages can be fixed rate or variable rate. It is important to know which you have so you can be prepared for potential increases to your monthly budget.

If you are on a fixed term:

• How much longer do you have until it's time to renew?
• Do you know what economists are predicting rates may be at that time?
• What will your new payments be?
• Will you be able to afford it?

If you have a variable rate:

• Do you have room in your budget to absorb an immediate increase in your monthly costs?
• How much of an increase can you tolerate in the mid to long term?
• When would be a good time to lock your rate in to prevent further cost increases? 

If fixed or variable:

• Can you afford to make principal payments to reduce your monthly cost burden over the long term?

Lines of Credit / Home Equity Lines of Credit – The interest rates on lines of credit are usually variable (though not always) and therefore the effects of increases will be similar to those of a variable rate mortgage. However, unlike a variable rate mortgage, there may not be an option to lock your rate in – meaning your only option to slow or offset rising interest costs will be to pay down the principal value of the debt. 

Credit Cards – Most credit cards use a fixed interest rate and therefore should not fluctuate based on the Bank of Canada's overnight rate. However, issuers do reserve the right to raise interest rates at their discretion – including as a response to an increase in the overnight rate – and they can do so without the card owner ever having missed a payment. Therefore, it is important to keep an eye on statements to be aware of your current interest rate and avoid expensive, unexpected increases to credit card debt.

How to Cope with Rising Interest Rates

The more debt you have, the more expensive interest rate increases will be for you. Therefore, the best and most effective way to cope with rising interest rates is to pay down your debt as quickly as possible. Some helpful steps may include:

• Cutting expenses wherever possible so you will have more money left over to pay down debt
• Pay down the highest interest rate debt first while making minimum payments on lower interest rate debts
• Finding ways to increase your income so you can make larger payments against your debt
• Applying for a consolidation loan for your high interest rate debts so you can pay the balance down faster while making the same payments

With the cost of debt increasing, you may also want to reconsider your current relationship with credit. To avoid getting further into debt, you may also want to:

• Avoid taking on the largest value mortgage, loan or line of credit you are offered
• Reconsider whether borrowing is the best plan for you right now and how it will affect your financial freedom
• Regularly contribute to an emergency fund so any unplanned or unexpected future expenses can be paid for with cash

If you've already felt the pinch of increased interest rates and are worried further increases to your debt costs will mean you can't pay your bills, an MNP Licensed Insolvency Trustee may be able to provide you with the Life-Changing Debt Solution you need. Call us for a free confidential consultation to learn which one might be best for you.