What Do Rising Interest Rates Mean to You, Part 1 PDF View
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If you’ve been following the news recently, then you’re aware that the Bank of Canada has raised interest rates for the first time in seven years. The rate it raised is called the overnight lending rate and they raised it from 0.50% to 0.75%. No sooner did they announce this than the Canadian Big 5 Banks followed suit by raising their prime lending rates from 2.7% to 2.95%. But what does that mean to you?
In the first of two articles, we’ll look at the effect of rising interest rates from the perspectives of both borrowers and lenders. In our second article, we’ll look at how rising interest rates affect the overall economy and what that might mean to your investments.
If you’re a borrower, then you owe money. Mortgages, lines of credit, credit cards, etc. are our borrowing tools, and for the last twenty years or so, particularly over the last seven, exceptionally low interest rates have made it an excellent time to borrow money. If you are currently a borrower, how will you be affected by this new change? Let’s look at an example:
Let’s say you owe $100,000 on your line of credit and you’re currently paying the prime rate of interest. Two weeks ago, that debt cost you $2,700 a year ($100,000 x 2.7%) or $225 a month. Now that your bank’s prime rate has gone up to 2.95%, that same loan now costs you $2,950 a year or $246 a month.
Perhaps your budget can handle a $21 increase a month, but if rising rates are a trend, many Canadians will be feeling the pressure to get their financial houses in order. We still don’t know for sure if this initial rate increase by the bank of Canada is the beginning of a trend; however, if your debts are higher than they should be, the Bank of Canada has just fired a shot across your bow.
On the other side of the table, let’s say you are a lender:
Looking at the example above, instead of owing interest on $100,000, you are receiving it because you lent money to a person or company. The $225 you received last month is now $246 a month.
Bonus!! But there’s a catch. Most people are not lenders in the way that our example above describes. Most people become lenders through their investment choices. If you own GICS, treasury-bills, banker’s acceptances, government or corporate bonds, bond mutual funds or exchange traded funds, you are a lender in one way or another. The governments, banks, insurance companies, or other corporate institutions that have issued these securities (let’s call them bonds) have agreed to pay a rate of interest per year to the holder of the security for a certain period of time. In essence, they are the borrower and you are the lender.
This is where the catch comes in. Typically, that interest rate you receive on your investment is fixed (it doesn’t change), and the period of time can range from a month to 30 years depending on the type of security. Using the example above again:
If you’ve bought a bond that pays you 2.7% of interest for the next 5 years, you’ll continue to receive 2.7% until your bond matures, rather than the new rate of 2.95%.
At the same time, because most bonds can be sold on what is called “the secondary market”, your bond is no longer worth what it was two weeks ago. Investors would rather receive 2.95% than 2.7%. As a result, the price and value of your bond will fall so that its value reflects the current interest rate.
This is something you’ll want to be aware of when you’re looking at your investment statements. Rising interest rates will cause bond prices to fall. Should you panic? Absolutely not. Like everything else with investing, panic is the enemy of a success. If you own individual bonds, keep in mind that regardless of the rate of interest you receive, those bonds have a set maturity date and you will get your money back at the end of that term (including the interest agreed upon – 2.7% per year in our example).
Everything else is just short-term noise.
If you invest in a bond fund or exchange traded fund, you don’t have a set maturity date, so there is a little more uncertainty. It’s important to remember; however, that a bond fund owns many bonds, often tens of hundreds of them in a given portfolio. Many of them are maturing on any given day which means the fund manager has an opportunity to reinvest in new bonds at the current higher rates. Bond managers also tend to be more active when looking for opportunities and have many strategies that can be used to give an investor an edge during a rising rate period. Please review our blog entitled “Buying a Portfolio of Bonds, making a Case for Investing in a Bond Fund”, to understand our belief at LGK Investments of Aligned Capital Partners Inc, why a good bond manager is worth hiring.
As mentioned in our introduction, please watch for our second article looking at how rising interest rates affect the overall economy and what that might mean to your investments.