More and more, Canadians are feeling the pinch of rising interest rates. Since March 2022, the Bank of Canada (BoC) has embarked on a fierce campaign to combat runaway inflation. The latest rate hike, which occurred on July 12, 2023, puts the key lending rate in the country at 5%.
While it appears the BoC is achieving noticeable success in its goal, the impact has not been kind to Canadians’ pockets, as they face ever-increasing interest costs on mortgages, lines of credit, and other debts.
In this article, we’ll explore what causes interest rates to rise, how different types of debts are affected by rate increases, and how to deal with the extra costs you may face.
Why do interest rates rise?
Interest is the cost of borrowing money. Therefore, taking out a loan will cost you more if interest rates increase. But why do rates rise in the first place?
Here are the three primary forces that drive interest rates upward:
1. An expanding economy. Interest rates change based on the supply and demand for money. An increase in the demand for money, and by extension, loans, will cause interest rates to rise, while a decrease in the demand for money will cause rates to fall. Therefore, during an economic boom, you can expect higher rates, as people are eager to borrow and spend. This is the same principle that applies to any good and service – the more the people want it, the more it’s price will increase.
2. High Inflation. The higher the inflation rate, the more interest rates tend to increase. The reason is that banks and other financial institutions charge borrowers more to offset the losses they incur in the purchasing power of the money they lend (inflation decreases the value of money over time).
3. Bank of Canada rate hikes. The Bank of Canada (BoC) is the entity responsible for regulating the supply of money in the economy. Let’s assume it believes the economy is overheating. One of the tools it can use to cool it down is to raise the interest rate it charges when it lends money to commercial banks (known as the Bank Rate), such as RBC and BMO. Naturally, when banks’ borrowing costs increase, they pass on the extra expense by charging higher rates on loans they issue to you.
Fixed vs variable rates
Lenders assign two types of interest rates to loans: fixed and variable.
With a fixed-rate loan, your interest rate will remain the same throughout your loan term. As a result, your loan payment amount will always stay the same.
Alternatively, under a variable-rate loan, the interest rate you pay may rise or fall during your loan term. What this means is that your loan payment amount may increase or decrease.
The interest rate on a variable-rate loan moves up or down based on changes in the prime rate. The prime rate is the interest rate that banks charge their most creditworthy customers – they use it as a foundation to assign rates to all other loans. Banks’ prime rates fluctuate based on the BoC’s decision to raise or cut its lending rate.
As rates climb, your debt obligations may grow if:
- You have a loan(s) with a variable interest rate
- You have a loan(s) with a fixed interest rate that you plan on renewing once it expires
Naturally, variable-rate loans are riskier during periods of rising rates, as you end up paying more. Conversely, fixed-rate loans are a safer bet, as your payments are guaranteed to stay the same for your entire term.
Therefore, if you strongly suspect that higher rates are on the horizon, it makes sense to lock in a fixed rate. Variable-rate loans are more favourable when rates drop, as you’ll benefit from lower monthly payments.
The impact of higher interest rates on different loans
So, how do increases in interest rates impact your debt? That depends on what types of loans you’re responsible for paying, the total amount of your debt obligations, and whether or not you’re applying extra payments toward your principal.
Mortgages are available with fixed, variable, and adjustable rates.
If you have a fixed-rate mortgage, you don’t need to worry about a spike in interest rates. Your monthly payment will stay the same for the remainder of your term.
If you have a variable-rate or adjustable-rate mortgage, the amount of interest you pay will increase.
Under a variable rate, your payments will remain unchanged, but a higher percentage of your regular payment will go toward interest rather than principal (unless you hit your trigger rate). This means that you’ll end up paying more interest over the life of your mortgage and take more time to pay it off in full.
With an adjustable-rate mortgage, your monthly payment will increase to reflect the increased interest charges. This can spell trouble if interest rates are rising sharply. The higher debt load can strain your budget, forcing you to make challenging financial decisions and possibly lead to severe debt problems where you miss payments. In the worst-case scenario, your lender will foreclose on your mortgage.
When rates rise, a fixed-rate mortgage can save you plenty of money and stress. However, remember that you’ll only enjoy this benefit until your mortgage term ends. Once it comes time to renew your contract, you’ll face higher rates.
A mortgage is likely your most significant liability, so it’s crucial to prepare for a potential increase in your budget as your term nears expiry. Using a mortgage calculator, you can quickly determine how much more you’ll pay.
Alternatively, you can contact your lender or mortgage broker several months before your term expires to learn what rates you qualify for and your expected monthly payment.
Check out our article on the impact of rising interest rates on mortgages for tips on offsetting the higher costs you may encounter.
Car loans are fixed-rate debt instruments with set terms and conditions. As a result, your monthly payment will stay the same as interest rates increase. This is good news if you financed a new vehicle purchase with a seven-year loan before the onset of higher rates.
However, suppose you plan to refinance your loan or lease a vehicle. In that case, you’ll likely be paying more each month, as you’re entering into a contract during a period of higher rates.
Line of credit and home equity line of credit (HELOC)
A line of credit and HELOC are variable-rate debt products that are very sensitive to changes in interest rates. Therefore, if the BoC decides to hike rates, you can expect an increase in your monthly payment almost overnight.
Lines of credit are very convenient during times of low rates. But they can cause immense financial hardship when rates spike, as you’re guaranteed to pay more interest to service the debt. While you’re unlikely to feel much of an impact if you only have one type of variable-rate debt, the extra costs can be substantial if you’re also responsible for a variable-rate mortgage and other high-interest debts.
A HELOC is especially dangerous during a period of high-interest rates, as your home functions as collateral for the loan. If you default on your payments, your lender can take possession of your property and sell it to recover the money owed.
Credit cards are among the most expensive types of loan products, with a typical interest rate of 19.99%. If you use them liberally, they can quickly lead to tremendous debt problems.
Luckily, credit cards typically carry fixed rates, so you don’t have to worry about paying more if rates increase.
Still, some brands come with variable rates, so checking your card’s terms and conditions is worth checking if you routinely carry a balance. You don’t want to get caught off guard.
Student loans, whether issued by government or private financial institutions, can be fixed or variable-rate loans.
Naturally, if you hold the fixed-rate variety, you won’t see an increase in your interest costs or monthly payments. If you have a variable-rate loan, you can expect an immediate increase in your rate and payment amount.
Note: The Government of Canada has eliminated interest on Canada Student loans and Canada Apprenticeship Loans as of April 2023. This is a continuation of the interest-free policy instituted in April 2021.
Personal loans typically are available only with fixed rates, so they’re not susceptible to rising interest rates. However, some lenders offer these loans with variable rates, so it’s worth checking your loan contract to be safe
How to manage debt when interest rates are heading up
When interest rates are trending upward, acting as soon as possible to address your debts is vital. As your borrowing costs increase, keeping up with payments and covering your day-to-day expenses will be increasingly challenging.
Lock in a fixed rate for as long as you can. It’s impossible to predict how high rates can rise. Therefore, your best bet is to choose fixed-rate loans over variable-rate loans to keep your payments stable. If you currently have a variable-rate mortgage, consider inquiring with your lender about converting to a fixed-rate.
Lengthen the amortization period on your mortgage. Extending your mortgage’s amortization period will reduce your monthly payment if you renew your contract at a higher rate.
Make a prepayment. Consider making a sizable prepayment if you’re facing a steep interest rate upon your mortgage renewal. A drastic reduction in your principal will translate to lower payments, as less interest charges will accrue. You can apply the same concept to a HELOC or traditional line of credit.
Focus on paying down high-interest debts first. While credit cards aren’t usually vulnerable to rising interest rates, the fixed rates they charge are already very high. The interest expense can consume a massive chunk of your income, leaving less money to cover other debts. Paying down your credit card balance will free up extra funds you can dedicate to interest-rate-sensitive debts, such as an adjustable mortgage.
Pay off variable-rate loans before fixed-rate loans. If you have no high-interest debts like credit cards, prioritize paying down your variable-rate loans. By doing so, you can avoid ongoing increases in your borrowing costs.
Increase your income and cut your expenses. Take on a side hustle or find other ways to bring more income so that you can contribute larger payments toward your debts. Cut costs as much as possible so you’ll have more money to apply to your debts. Maximizing your income while minimizing expenses is especially important for managing debt if you live paycheque to paycheque.
Are rising interest rates squeezing every last dollar from your bank account, and you’re anxious about being able to keep up with debt payments? A Licensed Insolvency Trustee at David Sklar & Associates can help you find a solution that will guide you toward financial freedom. Contact us for a free, no-obligation consultation to learn about your options for reducing or eliminating debt.
Photo by Karolina Grabowska