Lately there have been several media reports stating that an increase in interest rates is not a matter of if, but when.
Debt levels in Canada and the U.S. are rising and anyone paying interest on their debt is bound to be affected.
Here’s how I would recommend someone could change their finances to deal with a rise in interest rates.
Consumer debt is something many of us have but none of us want.
It’s usually the highest interest rate people pay on the money they owe and it will only get worse if interest rates rise.
I’ve never had any consumer debt but if I did, I would start putting more money towards paying it off when interest rates increase. Even if rates didn’t rise, I’d still want to pay it off first because it’s already expensive compared to other types of debt.
The interest on a student loan is deductible, but the interest on the loan for a new home theater system is not.
If interest rates went up by 1% I would start by allocating a greater percentage of my monthly income towards paying off the debt. For example, if I started the year by setting aside 10% of my monthly income I may consider bumping it up to 15-20% if rates went up.
Of course the difference would have to come from somewhere so I’d take a look at my monthly budget and see where I could find the savings. Some of the possibilities are monthly cable, travel costs, vehicle costs, spending less on groceries – anywhere I could cut down my monthly spending to make up the difference. In some cases it may be as simple as dining out less or spending less at the cafeteria for lunch.
In the past week I’ve received a couple emails from readers asking why I listed some reasons to avoid a 5 year fixed rate mortgage when rates could rise in the future.
There’s no disputing the security that a fixed rate mortgage offers, but it comes with a price; and in the large majority of cases a 5 year fixed rate mortgage is the most expensive option. Fixed rate mortgages have been more expensive than variable rate mortgages about 90% of the time in the past 25 years. Whether that will continue is anyone’s guess.
My mortgage is up for renewal this year so I’ll be paying close attention to interest rates.
If rates do increase I will likely go with a variable rate or 2-3 year fixed rate with favorable mortgage terms. A variable mortgage would give me the option to lock in a fixed rate at any time without penalty.
Related: How to Reduce Your Mortgage Penalty
Ideally I would want the option to increase my monthly payments so that I could put more money towards the mortgage in case rates rise.
The higher the rate increase, the more money I plan on putting towards the mortgage principal. The difference will likely come from the money I set aside each month for investing.
It makes more sense to invest rather than pay down a mortgage if the rate of return is higher than the interest savings. Of course this would change if interest rates rise and paying down the mortgage principal will become more of a priority for me if interest rates do rise.
Related: Mortgage Basics Everyone Should Know
Big Ticket Purchases
I don’t have any large purchases planned this year but if I did, an increase in interest rates would make me think twice about borrowing money for my purchases.
If I was planning on borrowing to pay for a large purchase like a basement renovation or vehicle and interest rates increased, I would want to calculate the total cost (including all interest). Many people only look at the cost of the item without factoring in the interest costs, which only get bigger the more time the loan is paid off.
Since the total cost would increase with a rise in interest rates I would want to save more to borrow less – reducing my overall interest costs.
Again, this money would have to come from somewhere so I would have to look at reducing other monthly expenses to save more for the purchase.
Conclusion: No one knows if/when interest rates will rise but it’s important to be ready if they do. A rise in interest rates would change my monthly spending so that I would avoid paying more interest. I’d focus more on paying off consumer debt, allocate more money towards my mortgage principal and delay large purchases so I could avoid paying more interest.
How would a rise in interest rates affect you?