GCCIBlog, Financial Planning, Retirement Issues and more

One of the good things about the past recession or depression as some people would call it is that the interest we pay on loans and mortgages have been at historical lows. Many people would say this might be the only thing good thing about this  recession. If you lost your job, or your home or have gone further in debt you probably are not interested in what is occurring with loan and mortgage interest rates.

However many of the worlds governments are letting their constituents know that interest rates are about to begin rising.  How much and exactly when interest rates will begin to rise is not yet known, yet most informed sources feel that they will begin to rise in the second half of 2010. There are various strategies that one should consider depending on whether you are an investor or a borrower.

Note that any suggested advice we discuss in this blog is just that advice. We do not have a crystal ball and we really have no idea what will occur, however it is one writers opinion. Make your own assessment , read lots of material and make your own independent decisions.

Investor Strategies

If you are an informed investor, then you probably have a diverse investment portfolio with blue chip investments distributed among stocks, mutual funds and bonds across the various market sectors. That’s a big mouthful, however the message is do not ever put all of your eggs in one basket!

Typically when interest rates go up, existing bond values fall to maintain the overall yield, while new bonds being issued will have to offer higher interest rate yields to match the market interest rate. Dividend paying stocks also will decline so that overall yields will match the going interest rates on the market.  Of course many other events can influence the value of the stock, such as corporate earnings and other market issues which will impact the overall value of the stocks value.

So what should you do when you see that the government is about to increase interest rates. If you are betting that the increases will be relatively minor, that they will not need to fight serious inflation, then you can take your time and be somewhat more careful about your plans.

Most people are long term investors, aiming at generating income and growth of their portfolios. With this in mind, fluctuations in interest rates and their corresponding impact are less troublesome. However there are some things you can do to make sure you take advantage of increasing interest rates and avoid the loss of income as interest rates decline.

Bond Ladders

Creating a bond ladder allows you to invest in bonds with maturities over various years. For example if you have $100,000 , then investing $10,000 with a maturity in subsequent years lets you take advantage of bonds maturing every year instead of all at once when interest rates are low. You may not be able to invest all of your money at the highest interest rates, however your overall average will be higher than the lowest market interest rate.

As interest rates drop, you may find that bond lenders may call their bonds early. With this option, which many bonds have, the bond owners can pay off their bonds early and issue new bonds at a much lower interest and save thousands of dollars. This is not a good situation for many investors who might be counting on this income. As you invest in bonds, always inquire whether the bond is callable or not and when. You will need to make your decision to purchase a callable bond, based on your assessment of where interest rates are headed.

We really like bond ladders with non callable bonds when interest rates are declining and especially when they are rising. We also like keeping approximately 5 to 10% of our portfolio in cash if interest rates are headed up so that we can take advantage of the increasing rates.  By cash we mean money markets or GICs with early maturity dates. You will not make much money, but every little bit counts  and you will be ready when a good deal comes along.

What to do If you are Borrowing Money

With interest rates currently expected to rise, what should you do if you have a mortgage or a loan, or planning to borrow a large sum of money?

If you believe interest rates are going to rise significantly, it may be time to lock in your mortgage or loan so that you will not be hit by a financial shock when they do increase. You may find that there are hundreds of dollars added to your monthly payment when interest rates do rise.

On the other hand if interest rates stay low for some time, you can actually save money by staying with an open mortgage with the interest rate tied to the bank rate. There is some risk to this approach because you could get caught if interest rates increase rapidly.

Bottom Line

If you are a risk taker, then you will probably take a more aggressive approach to keeping low interest rates on your loans and avoiding locking in your mortgage or loan for up to 5 years or more. On the other hand if you worry a lot or cannot withstand a financial shock, stay awake at night worrying about your debts, then locking in your mortgage and loan interest rates will protect you from fluctuations in the monthly payments as interest rates change! At least you will not lie awake at night worrying about this issue.

Comments are welcome as are suggestions about what to do in this current situation.

There has long been a discussion around whether a variable rate interest rate for mortgages and loans is better than a fixed interest rate for these same financial vehicles. The debate always gets interesting when interest rates are about to change and consumers get worried whether they will end up paying more interest because rates are rising and they did not lock in soon enough. Conversely many consumers also worry that they locked in too soon when interest rates start to fall. So what is the right strategy for consumers around this huge issue of fixed vs variable interest rates?

Well , we think there are a number of factors to consider and they will vary in importance for most people. As a result it is a very personal decision based on the financial position you are in, the plans you have for the future regarding your property and you ability to deal with risk associated with changing interest rates. We will try to discuss the major issues and provoke people to think about their situation before they make a decision.

Some Background First

A fixed interest rate loan or mortgage is just that. The interest will not change for an agreed to time frame, usually called the “term”. At the end of the term, the bank will offer you a new interest rate and term for your loan or mortgage if you have not already paid it off.

A variable interest rate loan or mortgage will vary in relation to the prevailing bank rate announced by the Fed in Canada or the United States. If it goes up, your bank is likely to increase the rate they charge you. If it goes down, they will lower the rate they charge as well.

If the bank rate is, let’s assume 2%, then the banks will charge you one or 2 % over that depending on how competitive your bank is for a total interest rate of 3 or 4%.

Factors to Consider

These factors are not listed in any relation to importance, since individual consumers may rank them quite differently based on their personal situation.

Stress - Some people just cannot deal with the unknown of whether the interest rate will change and whether your monthly payments will change or not. If it keeps you up at night worrying, why put up with that , lock it in.

Changing Monthly Payments – each time the interest rate changes, the amount of interest you owe and the corresponding monthly payment will change. As long as it is going down it is ok, however if the interest rate is going up and if there is going to be a significant impact on your budget, then you may want to switch to a fixed interest rate loan or mortgage.

Planning to Sell – When you sign up for a fixed rate mortgage you are saying that you will pay a certain amount for the life of the term based on the agreed to interest rate. If you plan to sell during that period of time and the interest rates have fallen, the bank is going to charge you a penalty plus administration fees to discharge the mortgage when you sell your home. The penalty will roughly amount to the difference in your rate and the rate that the bank will lend the money out at the time you close. This can amount to thousands of dollars, so it is good idea to think about this.

With a variable rate mortgage often you will only pay the administration fees to discharge the mortgage.

Saving Money – Variable rate loans and mortgages often have lower interest rates than the fixed rate loans and mortgages being offered by banks. This is only true at the time you take out the mortgage. Interest rates do change and they can go up and down, however at the time you sign, the variable interest rate is usually lower than the prevailing fixed interest rates. This is an excellent way to save money especially if you feel that for the foreseeable future , interest rates are not likely to change much.

Volatile Interest Rates – In periods of high inflation or in periods of economic down turns and depressions / recessions, the interest rate that is quoted by the banks can change often. During periods of economic growth and high inflation interest rates tend to rise. During recessions and depressions, interest rates tend to decline in order to stimulate the economy and get things moving.

Consumers should take this forecast of interest rate volatility into account when they are making their decision along with the other factors mention as part of their decisions to take a variable or fixed interest rate loan or mortgage.

Competitive Rates – Many news papers will list current interest rates offered by banks and other lending institutions each week. For the most part they are all pretty close since competition is pretty fierce, however it never hurts to have a discussion with your loan officer to see what kind of deal they may give you.

Sometimes even shaving a quarter percent off can make a big different in the total amount of interest you pay. It never hhurts to ask and the worst that will happen is that they will say no!

In Summary

Assess your risk tolerance for changing interest rates, assess the impact on your monthly payments, assess your plans to sell or keep your home and assess the next several years in terms of were you think interest rates are headed as inputs to your decision. Note that you can and should compare fixed and variable interest loans and mortgages from various companies to ensure that you obtain the most competitive rates.