Without question, there has been a benefit to low interest rates. But there has also been a downside. So where are rates going and what can we expect?
The benefit of low interest rates is businesses have experienced lower debt costs and the ability to hire and fund expansions which in turn increased employment and profits and returns for equity holders. Mortgage holders have experienced lower payments and even smarter mortgage holders have increased their payments to pay debt off faster. Tax payers have funded less debt repayment than could have been required given our significant government debt and have experienced lower taxes.
The downside to low interest rates culminated in the financial collapse of banks in the US in 2008-9. There is a cost to borrowing and when money became so inexpensive to borrow that it was almost free, stupid things happened – like banks giving money to people who could not pay it back. To a lesser extent in Canada we are experiencing the continued belief that money is almost free. Retirees retiring with debt, new homeowners borrowing to the maximum and continued use of equity lines of credit to fund lifestyle. The concern of course is when interest rates do begin to rise, what will happen?
Let’s get this comment in first – rates will begin to rise – the laws of economics confirm this – unfortunately the laws of economics cannot predict when this will happen. So preparing for higher rates is just prudent.
If we discount the worst thing that could happen (another global financial crisis) and the best (nothing will happen) we’ll likely see something like this:
- Inflation will likely precede the rise in rates. We are seeing some increases in inflation now but it has been muted for consumers with the fall in gas prices
- Rates will not rise quickly – governments know they cannot afford for this to happen.
- Real estate prices will level off and potentially decrease for a few years to adjust to the new reality (remember 1994 to 1995? This can happen!)
- Tax breaks will stop and taxes likely increase for the middle class.
- The 20- 25% low income families (who cannot borrow and therefore do not have any debt) will be impacted by inflation and governments will respond with specific low income tax breaks to help
- The 50-60% of individuals either without any debt or working with financial advisors likely have (for the most part) contingency plans in place or simply can afford higher debt repayment costs.
- The 20-25% of families who have extended themselves with high mortgages or debt will go bankrupt or sell their homes at lower than expected prices.
These predictions did not take a lot of intelligence to come up with – it’s exactly what has happened before. The lesson here is to recognize that this is the time to take advantage of low rates and to strategically pay down debt.
After discussing the above with clients, and considering the equity market has had significant returns which historically suggests will continue, I do get a question with an answer that is not always clear – “So, Mr. Smarty Pants, do I pay down my mortgage or invest in my RSP?” This is a topic for another time – or a phone call.
The article linked below may give you some additional insight.