On July 12, the Bank of Canada announced it will be raising the overnight rate – often referred to as the policy interest rate, by 25 basis points from 4.75% to 5.00%. In doing so, the prime lending rate offered by financial institutions increased to 7.20%. This increase is a continuation in a string of rate increases meant to tame inflation within the country.
When a change to the policy interest rate occurs, it is often an indication of the direction that the Bank of Canada aims short-term interest rates to move in. It is well understood that the Bank of Canada uses their key interest rates as a tool to manage inflationary pressures.
While inflation can present itself in various ways – whether it be demand-pull, cost-push or built-in, the root of its occurrence is primarily related to the supply of money within the economy. When the money supply is increased, it results in money losing its purchasing power and consequently results in some level of inflation.
By increasing the overnight rate, the Bank of Canada hopes to illicit a dampening effect within the Canadian economy. Although this is a complex process, the basic idea is to discourage consumer spending habits through non-favorable borrowing rates, meanwhile, the higher rates incentivize people to save, thereby slowing down the use of money within the economy.
As a borrower, how does this affect me?
Commonly, the people most impacted by interest rate increases are those with mortgages.
If you have a fixed-rate mortgage, there will be no change to your payment or interest rate until the end of your term. If you are nearing the end of your term, it may be prudent to begin preparing to renew your mortgage in a higher interest rate environment. If cashflow permits, you can reduce the strain of higher interest payments in the future by making some form of principal only payments on your current mortgage while you are benefiting from a comparatively favorable rate.
If you have a variable rate mortgage, your interest rate will increase. Variable mortgages are offered based on a discount on the prime rate, so while the discount will remain the same, as the prime rate increases your total mortgage interest rate will change accordingly. The impact on your mortgage will differ depending on whether you have a fixed-payment variable mortgage or an adjustable rate mortgage.
If you have a fixed-payment variable mortgage, you may not see any change to your payment; however, a larger proportion of each payment will be allocated to interest which will lengthen the overall amortization of your mortgage. If rates continue to increase you may see an increase to your payment if the minimum interest amount is not met, which is known as reaching the trigger rate. Details on the minimum interest amount would be detailed in the terms of your mortgage. If your trigger rate is reached, you will likely be given the option to either:
- Make a lump sum payment against your outstanding balance
- Increase your principal and interest payments
Some mortgages also allow for you to lock-in a mortgage rate for the remaining term of your mortgage. These lock-in rates will generally be higher than your current rate as they factor further rate increases into the offering. The difference between the lock-in rate and your current rate can be viewed as the premium for the sureness in future payments – much like the decision to choose a variable rate, or fixed rate mortgage.
An option that we feel is more effective in minimizing rising rate exposure for a mortgage, is to determine your lock-in rate, and choose to increase your payments based on that higher rate. In this respect, you would have the benefit of putting further payments towards principal at a much lower variable interest rate. These extra payment amounts can act as a shock absorber to future rate increases and help to keep you on track towards your overall mortgage goals.
This increase to the prime lending rate will also have an immediate impact on other personal credit facilities such as a home equity line of credit or personal line of credit.
Although these rate increases have had the intended effect of reducing inflation as measured through a reduction in the CPI index, it remains above the Bank of Canada’s stated goal of 2%. Due to this, we may see further rate increases in the near-term, meaning consumers should factor this into their spending habits and adjust household cashflow accordingly.
What about my assets?
As an investor, it is important to be cognizant of how elevated levels of inflation impact your assets and the actions you can take to limit its effects.
With rising inflation causing higher prices for consumers, investors can find this especially costly, both on a personal and corporate basis, by holding large sums of cash with no potential to get ahead of inflation. A better alternative would be to prioritize holding shares in quality businesses that pay their shareholders. Traditionally, such businesses have lower than average capital costs and have pricing power to pass on rising costs to their customers. Owning stock in these companies allows shareholders to participate in rising profitability through increasing dividend payments and stock price appreciation.
What can I do personally to hedge against inflation?
- Consumer Spending Habits: With the rising cost of goods, the most powerful tool we have as consumers is to reassess our current spending habits and adjust these habits where possible to lower our cost of living. For some, this might mean cutting back on their dining-out budget, for others perhaps this means scaling back their vacation budget for the year.
- Take on new debt sparingly: While we have rising interest rates and historically high inflation, be wary of taking on any new debt unless it is helping to free up monthly cash flow. Adding a new monthly payment to your budget only reduces your financial flexibility in this increasingly costly market environment.
- Shop strategically and maximize loyalty and rewards programs: Loyalty and rewards programs can help further expand savings by ensuring you are rewarded for spending your hard-earned cash. Further, you can tailor the rewards based on what might be of value to you, like cash back as an example. For some, accruing reward points that can be used to subsidize annual vacations or monthly grocery spending could make the most sense for their circumstances.
- Consider delaying major purchases: With prices currently elevated due to supply chain challenges and supply shortages, waiting to make that next large purchase, be it your next car or major home renovation, could potentially save you thousands of dollars as the market readjusts and supply for these goods returns to normal levels of supply relative to demand.
If you have any questions about how further rate hikes, inflation, or implementing certain inflation hedging strategies would impact your specific situation, please feel free to reach out to your TPC Financial Group advisor or visit our website to set up a meeting.