Dale Jackson

Personal Finance Columnist, Payback Time

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The pedal has hit the metal on interest rate hikes. As higher borrowing rates spread through the economy, savers will be in the driver’s seat and borrowers could get run over.

The fallout will impact just about every household and neighbourhood in the country, but in very different ways as the immense power of compounding widens the gap between those who accumulate wealth and those who can only stand by and watch it evaporate. 

THIS IS NOT A DRILL

We’ve been warned about the end of rock-bottom borrowing rates for decades but now things have gotten real. 

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Last week’s half-point hike doubled the Bank of Canada benchmark rate to a still paltry one per cent, but it’s just beginning. This week, Scotiabank Head of Capital Economics Derek Holt said there is a compelling case for up to a full-point rate increase in June to tame sky-high prices.

Other economists are close behind as they begin to question the Bank of Canada’s ability to rein in what appears to be runaway inflation. Let’s remember the Bank of Canada’s target is inflation at two per cent. It surged 6.7 per cent year-over-year in March.

Interest rates are still low by historic standards; yet the all-time high of 16 per cent in 1991 can not be far from the minds of bankers and baby boomers. No one planned it that way back then. 

SAVERS FEELING THE LOVE

As higher benchmark rates trickle through debt markets, those who save will be rewarded with higher yields on savings accounts, guaranteed investment certificates (GICs), government bonds and investment-grade corporate bonds.

Already, longer term GICs have hit four per cent. In a recent report, BMO Chief Economist Douglas Porter marvelled at the speed that five-year Government of Canada bond yields forged above 2.7 per cent on Tuesday — at that point, it was the highest in more than a decade. By Friday, the five-year yield was around 2.83 per cent.

“While the level is notable, it’s the speed with which conditions have changed that is truly remarkable. Just one short year ago, these yields were still below one per cent,” Porter wrote in his report.

GRIM OUTLOOK FOR BORROWERS

On the other side of the interest-rate gap, the financial burden could grow just as quickly for borrowers who have not heeded the warnings to rein in their debt.

And there are many. According to Statistics Canada, the seasonally adjusted balance of home equity lines of credit (HELOCs) rose one per cent to $162 billion in February; the fastest monthly increase since 2012 and the fifth straight month of increases.

The average Canadian household, according to StatsCan, currently owes a record high $1.86 for every dollar it brings in. In the 1990s, that figure was 90 cents.

Those who hold variable-rate debt have already started feeling it. Those who had the foresight to lock in to a fixed-term rate can expect a shock when the term is up.

As a rough example, monthly payments on a mortgage of $400,000 at 1.5 per cent, spread out over 25 years are about $1,600. At four per cent (under the same circumstances) those monthly payments jump to $2,100.

Coming up with an additional $500 each month will be crippling for the average Canadian household. Trying to do it while contending with inflation could be devastating.   

HOW DID WE GET HERE?

Behavioural scientists call it human nature; we want what we don’t have right now and we’re reluctant to take measure that only provide gratification some time in the future.

But one fact that savers might understand over those on the other side of the divide is the awesome power of compounding.

To illustrate, here’s a simple example from a standard online savings calculator: After 25 years, $100,000 plus $500 a month (using the example of higher borrowing costs rolled into the debt) compounded annually at a rate of five per cent comes to $625,000.

Unfortunately for borrowers, compounding works both ways.

Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email dalejackson.paybacktime@gmail.com.