This past week, the Bank of Canada announced an increase in the BoC rate of 0.25%, causing the chartered banks to increase their prime rate to 3.45%. The chartered bank’s prime interest rate is the basis for all retail lending. A familiar term is prime plus 2%. Prime plus 2% would mean the effective interest rate for retail borrowers is 3.45% plus 2% or 5.45%.
Although a 0.25% increase doesn’t sound like much, especially to those of you who’s mortgages are locked in for the next 5 years at a lower rate, it is important to understand how increasing rates constrict the availability of credit. Note that a healthy flow of credit is essential to the debt-based system we live in today.
For example, think of someone kinking a water hose. The harder the hose is kinked, the less water flows through the hose. This same concept can be applied to the flow of credit as interest rates continue to rise.
If interest rates spike rapidly, it will become more expensive for governments (federal, provincial, and/or municipal) to borrow money. It may also cause the housing market to go into decline, consumer debt to become more expensive, increase corporate interest expense depressing profitability, and bond investors are likely to see capital losses in their investment/retirement portfolios.
The housing market
Currently a $300,000 mortgage at 3% interest would have payments of $1420 per month. If you have made a 10% down payment then the market value of the house would be $330,000.
If mortgage interest rates were to increase to 6% with purchase terms remaining the same, the mortgage amount the purchaser could afford drops to $230,000. If we apply the same 10% down payment, the most the buyer could afford to pay for the same house would be $253,000. This is a 23% decline in price to maintain the same affordability.
On the other hand, if you have already bought a home and aim to maintain that $300,000 mortgage and are now faced with a 6% interest rate, your monthly payment jumps to $1920. That is an increase of 35%, or $500 per month.
However, The Bank Act stipulates that residential mortgage holders shall not exceed 32% of their gross income for shelter/mortgage costs. Most banks have even tighter lending restrictions. Therefore, in the above examples of increasing interest rates, the borrower is limited to a lower offer on his prospective purchase. If a home owner is already running close to the 32% gross debt service ratio, the terms of the existing mortgage may run in to trouble.
Interest bearing investments
Bond investing is a staple in the investing industry (for more information on bond investing visit https://www.investopedia.com/terms/b/bond.asp). Virtually all pension funds and many mutual funds have interest bearing investments (bonds) inside them.
Any mutual fund that has a descriptive name like bond, mortgage, or any income title; high income, monthly income, income & growth, balanced etc all have some component of bonds.
Corporations and Government at all levels regularly issue bonds to finance their operations. For example, they will issue a $1,000,000 bond that pays 3.5% annual interest for 5 years. Interest is paid to the investor every year and principle returned at the end of the 5 years. These issuers of the bond do not repurchase or redeem these bonds from investors before maturity. The only exception to this rule is Canada Savings Bonds.
However, investors may be in need of money at any time, so a secondary market has developed to buy and sell these bonds before their maturity date.
There are three criteria to help establish the secondary market for bonds:
- The maturity value is always fixed and does not change.
- The interest rate is fixed at the date of issue and does not change.
- This leaves the purchase price to be the variable component if you want to sell.
Example of how bond investing returns work: If an investor purchased a newly issued, 10 year, $100,000 bond today at 3% interest, he would pay $100,000 today and get $100,000 in 10 years time. The 3% interest would be paid out every year for the 10 years, giving the investor $3,000 per year, for a total of $30,000.
If interest increases to 6% overnight, the selling price of the 3% bond would be affected in a big way. The maturity value remains $100,000, the interest coupon is fixed at $3,000 per year for the entire term.
However, if the seller of the existing 3% bond wants to find a buyer, the prospective buyer would likely prefer purchasing a bond that pays 6% interest rate. The seller of the 3% bond would need to deeply discount the sale price of his bond to the prospective buyer to incentivize him to purchase the 3% bond over the 6% bond.
Discounting the sale price would reflect the fact the the purchaser would only be getting $3,000 per year (3%) instead of his anticipated $6,000 per year (6%) from any other bond seller. For the seller to make the 3% bond as attractive as the 6% bond to the expecting purchaser, the seller would decrease his price to $77,920. This would make the overall return of the 3% bond, 6%.
The 6% return would be composed of the 3% annual interest payment plus the extra $32,080 received at the time of maturity. If the seller concludes the sale, they will generate a $22,080 or 22% capital loss!
- The example of interest rates jumping from 3% to 6% overnight is extreme and unlikely, however it shows how critical interest rate hikes can be. We have just experienced 36 years of falling interest rates from 20%+ in 1980s to the current 1-2% range, so these capital loses have not been a usual occurrence for most people.
- As we watch interest rates rise, expect to start seeing capital losses generated in bond investments.
The low borrowing rates of today and the corresponding even lower interest rates payed on savings accounts is not healthy for society’s long-term sustainability. For the last 80 years, people and companies were able to borrow at a rate averaging 6%, even with the fluctuations during different decades. Banks would pay savers a corresponding 3-4% for their deposits to fund these loans.
At a 6% loan rate, both borrowers and bankers have to assess the risk, to understand if the loan would be economical, and if they can pay back both the principle and interest. The savers would get a modest return for depositing their money in the bank.
Today’s low borrowing rates allow people to pay more for something than it is actually worth. Theoretically, the drop in “interest cost affordability” justifies a higher offering price. However, such low interest rates do not offer a strong incentive for savers. (for more on interest cost affordability visit https://www.investopedia.com/terms/i/interest_cost.asp ).
The Canadian economy will adjust to increasing interest rates if these increases are modest and spread out. Companies and individuals will be forced to adjust by reallocating or cutting back expenses in order to pay the increased interest costs. It becomes challenging when interest rates increase dramatically and companies and individual consumers cannot cut back expenditures enough to afford the increased interest cost.
It is important to start thinking of ways to cut back now so you are prepared when the rates increase even more. Contact your Forbes Wealth team if you would like to talk further about ways to get prepared.
Next week we will be talking about some of the positive aspects to rising interest rates and how it can signal a healthy economic trend.
UPDATE: Macquarie, Capital Markets Canada Ltd, expects only one more rate hike in either April or July 2018.