It's hard to know where interest rates are heading in 2019. A few months ago, economists expected that the Bank of Canada's (BoC's) key rate would continue to inch up to around 3% throughout 2019. Now, with uncertainty in the Canadian economy, this rate might stay at 1.75% for longer than initially expected.
This is good news for those who have high levels of debt as the cost of borrowed money will stay ‘cheap’ for longer. However, this reprieve may be short lived since the BoC has indicated that it is still planning to incrementally increase the bank rate to around 3% moving forward.
What are interest rates?
The policy bank rate (also called the target overnight rate, key rate, or benchmark rate) is set by Canada's central bank, the BoC, and is the interest rate that financial institutions use when they lend to each other. The rate is primarily used as a tool to help manage economic growth and inflation. When the economy is doing well and inflation is increasing, the BoC will raise the rate to 'cool things down'. When the economy is struggling, the BoC will lower this rate to spur economic growth. A lower rate encourages business to borrow more (since money is less expensive), which means they will buy more equipment and hire more employees. When the policy rate changes, it typically impacts what rates lenders will offer on products like mortgages, lines of credit, and car loans.
Keep in mind that the BoC interest rate is lower than the actual rate you will pay on your mortgage. The policy rate is 1.75%, but it's difficult to find a five year variable mortgage rate below 2.6% - banks are in the business of making money after all.
You might hear financial institutions use the term 'prime rate'. When the BoC raises the policy rate, it becomes more costly for banks to borrow money, which means they have to raise their individual prime rates to cover higher costs. Certain financial products that your bank offers are tied to the prime rate.
Why are rates low today?
When the financial crash happened in 2008, the BoC quickly dropped the key rate from 4.25% to a low point of 0.25% (see below) in an effort to spur economic growth and help avoid a deeper recession. As a result, Canadians have enjoyed very low interest rates for the past decade.
Source: Bank of Canada & Canadian Press
Are higher rates a concern?
Despite the difficult financial period in 2008, Canadian housing prices didn't decline as drastically as in the US. In fact, the newly lowered interest rates made borrowing cheap and actually lead to an increased demand for housing, which in turn pushed housing prices up. Homeowners started to feel wealthier and some started borrowing against their home equity to fund renovations, vacations and new cars.
Consequently, about one third of Canadians fear bankruptcy as interest rates rise. Additionally, 58% of respondents in a recent CBC poll said that they would have to change their spending habits if their monthly debt payments increased by more than $100.
Many Canadians have only seen relatively low interest rates, especially those who joined the workforce after 2008. Many don't realize that in the 80's prime mortgage rates were over 20% for a short period! It's unlikely that rates will increase to such high levels, but it does highlight that rates can fluctuate.
The below chart, which shows household debt as a percentage of income, succinctly captures the fact that Canadians, at 173%, are carrying too much debt.
Source: OECD (2018), Household debt (indicator).
While no one has a crystal ball that can perfectly predict the fate of both the Canadian economy and future interest rates, there are a few facts to consider. Firstly, rates have been low for some time and there will likely be a return to more normal levels. Secondly, Canadians are carrying high amounts of debt, and those who are unprepared might struggle when rates rise.
The follow up post will discuss what you can do if interest rates increase.