It pays to understand the Bank of Canada overnight rate increase

Managing your monthly cash flow can be tricky during the best of times.

Throw record inflation into the mix and you’ve got a situation where many people are being financially stretched to the max. In fact, a recent survey has discovered that 31% of Canadians currently don’t earn enough to pay their bills—with almost half (of those surveyed) finding themselves within $200 of insolvency. If you’re one of those people living paycheque-to-paycheque (and relying on credit to get by), the prospect of yet another Bank of Canada (BoC) rate increase can be nerve-wracking.

Yet regardless of where you happen to be on the pay grid, the changing BoC rate is something that affects everyone.

Mortgages, credit cards, personal loans, lines of credit, investments; these are all impacted by the BoC overnight rate. The greater the change to that rate (whether it be higher or lower), the bigger the impact—which is why it’s important to understand how that change could potentially affect you, your money, and your financial plans in both the short and long-term.

But first, how (and why) does the Bank of Canada influence interest rates?

In a nutshell, the BoC’s role is to promote the economic and financial welfare of Canada. One of the ways the BoC does this is through monetary policy, the goal of which is to contribute to solid economic performance and rising living standards for Canadians by keeping inflation low, stable, and predictable. The BoC implements monetary policy by raising or lowering the target for the overnight rate, which is the interest rate at which major financial institutions borrow and lend one-day (or overnight) funds among themselves. Changes in the target overnight interest rate lead to changes in other market interest rates and therefore to changes in the demand for credit, the demand for money, and the demand for bank notes.

The BoC considers a 2% inflation rate to be the ideal.

Inflation targets in developed economies are usually set at 1% to 3% per year. Targeting an inflation rate that is too low or too high could create problems. An inflation target that is too low might lead to higher unemployment, restrict the central bank’s ability to support a recovery in times of recession, and increase the chances or frequency of deflation rather than inflation. Of course, no one wants to have an inflation target that is too high either, as inflation costs can be considerable.

Have a mortgage? You’re going to pay more.

If you have a mortgage, how much (and when) you’ll feel the impact of any rate increase will depend on whether your mortgage is variable or fixed.

If your mortgage is variable, the amount of interest you’re charged is tied to the overnight rate. Financial institutions, in turn, pass on any rate increase to you immediately.

If you have a fixed rate mortgage, nothing will change until the current term ends (and it’s time to renew). By then, the rate may either be higher, around the same as it now, or lower. It all depends on how the economy plays out in the interim. That’s because your fixed rate is tied to the yield (or interest rate) of bonds. (It works like this: If the five-year Government of Canada bond is at 0.5%, the banks would take this rate and add percentage points to cover their costs and make some profit. If they add another 3.5% to that bond rate, their prime lending rate would be 4%. …which might be discounted in competitive markets for ideal borrowers.)

Will you pay more interest on debt?

That, again, would depend on whether interest is being charged at either a fixed or variable rate.

Some types of debt, such as credit cards for example, charge interest at a fixed rate, which would not increase with any change in the BoC’s overnight rate.

But that doesn’t mean that debtors should be complacent.

“If you’re being charged a fixed rate on your credit card, you should still take action to pay it down”, suggests Educators Financial Group Certified Financial Planner professional Darryl Martella. “The rate of interest on some credit cards is so high, it’s one of the first places to evaluate when looking to save money. For those of you with lines of credit, something else to keep in mind is that LOCs are linked to the prime rate, which means your rate of interest will also rise, regardless of whether your LOC is secured or unsecured. So, be careful of how much of a balance you’re carrying on those credit lines—because the higher rates climb, the more difficult it can be to pay off.”

Value of advice: when it comes to paying down debt and building up savings

When it comes to your investments, you may be surprised to learn that interest rate increases have the opposite affect on bonds and stock valuations.

“While low interest rates have helped support fixed income (bonds) and stock returns over the past few years, rising interest rates actually drive bond prices down,” explains Darryl. “That’s because on the day an investor decides to sell their bond, current market rates determine the price. It will sell for less when interest rates are higher than the bond’s rate and for more when interest rates are lower. Usually, the more years the bond is from maturity, the bigger the price change.’

Learn more by reading: Why bond prices fall when interest rates rise

We totally appreciate that it can be a lot to wrap your head around when it comes to fully understanding the impact of BoC rate increases on your finances.

Educators Financial Group can help you to make sense of it all.

From debt, savings, and investments to your ultimate financial goals, we can answer your questions, alleviate your anxieties, and work with you to put together a solid plan for the future.

Have one of our Mortgage Agents contact you.

Sources:
https://www.bnnbloomberg.ca/31-of-canadians-don-t-earn-enough-to-cover-their-bills-survey-1.1753377
http://www.pearsoned.ca/highered/showcase/ragan/pdf/9780321685537_ch29.pdf
http://www.frbsf.org/education/publications/doctor-econ/2007/march/inflation-targeting-monetary-policy-costs-benefits/
http://www.bankofcanada.ca/rates/indicators/key-variables/inflation-control-target/
http://www.moneysense.ca/spend/real-estate/mortgages/do-bank-of-canada-rates-impact-you-10-questions-answered/
http://www.cbc.ca/news/business/still-a-borrower-s-world-what-this-week-s-rate-hike-means-for-your-finances-1.4204180
http://www.tridelta.ca/articles/

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