Planning in a changing economy

Interest rates have reached a historic low. Investors are searching for secure investments earning 2.75 per cent and settling for 2.5 per cent and 2 per cent. By comparison, in the 1980s, a 30 year bond earned 18 per cent and mortgage rates were over 20 per cent.

How have many Canadians responded to today’s low interest rates? They have accrued huge credit card balances and maximum debt levels. If you look back 60 years ago, our great-grandparents likely never applied for a credit card, and worked to pay off their mortgages early. In fact, today many private corporation business owners are still reluctant to borrow. Have interest rates reached the bottom? It is unlikely they will drop further, however, never say never. In any event, Canadians should be preparing for the time when interest rates will rise.

If you are one those individuals who have reached their credit limit, ask yourself the following questions:
If you had to accept a decrease to your income of 10 per cent, for example $60,000 to $54,000, would you be able to manage your finances? What would suffer?

1) Savings
2) Cut back on luxuries, for example take-out food, evenings out, new wardrobe
3) Leave the car at home and ride your bike or take the TTC
4) Need for a second job to pay credit cards, rent, mortgage and other debt
5) Cash in RRSPs until you can get a second job.

If you selected 4, 5 or 4 and 5, it is time start reducing debt. Why? Because borrowing rates will not always be this low. For some individuals, an increase in interest rates would be equivalent to a 10 per cent decrease in income.

Consider the following example:

Trixie and Dan have a $250,000 mortgage coming up for renewal in 4 years. The interest rate for their current mortgage is 4.62 per cent. Their mortgage payments are $1,400.41 per month and property taxes are ~$370 per month for a total payment of $1,770.41 per month. If Trixie and Dan’s mortgage renews at 7.2 per cent, their new payment will be $1,783 per month plus property taxes, for a total monthly payment of $2,153, an increase of $383 per month.

Over a year, the increased mortgage payment will cost an additional $4,596, or more accurately $5,975 after tax (assuming a 30 per cent tax rate). Effectively, the increased interest rate on Trixie and Dan’s mortgage is equivalent to about 10 per cent of Trixie’s income of $60,000 per year.

If we look further into Trixie and Dan’s situation, after paying all their bills each month and renovating their home, they have nothing left over to put aside for a rainy day. How will they manage a higher mortgage payment? Barring any emergencies, Dan and Trixie have four years to reduce expenses and apply any extra earnings over the next four years to reduce credit card balances.

Note – credit card balances! Why pay off credit cards balances first? Because they are charging higher interest rates than 30-year bond rates were paying in the 1980s. The average interest rates for credit cards can range anywhere from 16.99 per cent to as high as 24.99 per cent. To remain financially stable it is essential to reduce credit card balances. One might say it’s time for austerity to become fashionable!

Recently, I overheard someone use the term happinomics. When asked to define the term, they described it as the relationship between money and happiness. While austerity may seem a harsh reality today, there is no doubt that not having enough money leads to unhappiness.


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