The impact on savers and borrowers
Inflation has been pushing the prices of everything up – not just in Canada but around the world. Canadian inflation rose to an annual 5.7% rate in February. After a year of insisting that this spike in inflation was “transitory,” central banks around the world have started fighting inflation in earnest – it wasn’t so temporary after all. The Bank of Canada was one of the first off the mark, and has now raised its policy rate twice, by a total of half a percentage point, from zero to 0.5%. It’s still pretty low. But that little rate hike will reverberate through the economy, affecting every lending rate there is. And they’re only just getting started.
As always, there will be some winners and some losers as rates ratchet up. In the losing camp will be those who have taken on too much debt, thinking that rates will never rise. Winners will be those benefiting from the cascade effect of rising rates, such as those looking for interest income.
The question is, what can you do to benefit from this and avoid being on the losing side?
Benefits for savers
For the past several years, interest paid on liquid, risk-free cash deposits at banks and credit unions has been near zero. But that’s not actually risk-free, is it? Not when you have a few thousand dollars just sitting in a bank account earning nothing. And in fact you are losing money because inflation is eroding the purchasing power of that money every second of every day. The same goes for such savings instruments as guaranteed investment certificates, which offered rates scarcely better than zero, even for five-year terms.
For risk-averse savers, this has been a nightmare. But that might be gradually changing as the Bank of Canada continues to raise its policy rate. A recent survey or rate tracking website ratehub.ca showed best rates for high interest savings accounts now offered at anywhere from about 1.5% to 2.0%. Some of the big banks still offer their “high interest savings accounts” at rates of less than one percent. But that will gradually begin to change.
Similarly, GIC rates are gradually rising, with one-year GICs offered at as much as 2.25% and five-year GICs at as high as 3.2%. Still not great, but better than the rates were a year ago at around one percentage point less.
GIC laddering strategy
For risk-averse savers, this could be a good opportunity to use what is called a “laddering” GIC strategy. This means that with your savings fund, you purchase several GICs with staggered maturity dates. Here’s how it works:
- Divide the money you intend to save into separate amounts, or buckets; invest each bucket in a GIC with a different maturity term from 1 to 5 years.
- Once each GIC matures, cash in the GIC if you’ve met your savings objective, or use the proceeds to buy a new GIC with a five-year term. That way, you’ll be able to take advantage of any higher rate that may prevail when your GIC matures.
- You can customize the amount you invest in each GIC based on your savings goals.
With this technique, you’ll also maximize returns, by continually rolling over maturing GICs into higher-rate, longer term GICs. The laddering strategy also cuts interest rate risk, by letting you continually take advantage of higher rates, and hedge against rate declines as your higher rates are locked in at the long end of the ladder. In addition, you have a small measure of liquidity, since you will be able to access your shorter-term funds in 12 months or less.
Rates on consumer loans will also start rising as the Bank of Canada’s policy rate increases over the rest of this year.
For those with large floating rate lines of credit, this could be a good time to consider locking in the rate (that is, turning it into a regular personal loan with a fixed term and fixed interest rate). This is still an attractive option now, while rates are still relatively low.
Similarly, if you have been considering taking out a loan, for home improvements, for example, now might be the time to take action, again, while rates are still low. But don’t borrow just for the sake of a lower rate. Be sure it’s something you need, and that you’ve budgeted for the payments.
As for car purchases or leases, in the current economic environment, you may not have much bargaining power on either pricing or interest rate, because of supply shortages and high demand. Borrowing now, when rates are low, might be the best option if the purchase and payments fit into your budget. And if you’re trading in your late model used car, remember that used cars are in high demand right now and command premium prices. Use it as a bargaining chip to reduce the purchase price of your new car and thus cut the amount you have to borrow.
Mortgages are a bit more complicated. Those with variable rate mortgages might consider locking in a lower rate now instead of waiting for the rate to reset. But much depends on the terms of the mortgage. Consult with your financial advisor to see which strategy works best for you. Those shopping for new mortgages, might consider a fixed-rate mortgage right off the bat so you’ll know fixed your monthly payments for the entire term of the mortgage. Again, because everyone’s financial situation is different, there is no one-size-fits-all solution. Consult with your financial planner to weigh the pros and cons of each option.