How Rising Interest Rates Affect You and Your Debt
As Albertans, we have always been an adaptable and resilient bunch. Historically, we’ve successfully navigated the bumpy terrain of fluctuating oil prices, harsh winters, and challenging economic landscapes. Some of you may even remember when the Back of Canada prime lending rate jumped as high as 21% in the early 1980’s making it difficult to make ends meet. We’ve been in a unique situation for the last 15 years whereby interest rates have been low, leading to people taking on more debt. The current uptick in interest rates is already impacting our daily lives, and if you have taken on debt you may be facing an additional financial challenge.
When interest rates start climbing, it’s like a game of dominoes for our money management. Everything from our home budget to our monthly loan payments feels the ripple effect. It can make juggling our finances a bit like a high-wire balancing act, demanding more careful and challenging financial planning. But, with careful planning and understanding, we can navigate through these changes.
In this blog post, we will aim to help you understand the outcomes of increasing interest rates on common loans, such as personal loans, mortgages, car loans, and student loans, and provide suggestions on how to manage this sea of change. We are here with you every step of the way, breaking down complex concepts into digestible pieces of information, peppered with real-life scenarios, and valuable advice.
How Do Interest Rates Work?
Interest rates, which fluctuate over time, are the cost you pay to borrow money from a lender, whether it’s for a mortgage, line of credit, or other types of loans. These rates are determined by your financial institution and should be clearly detailed in your loan agreement, a document that also outlines your rights regarding information on your loan. Typically, lenders offer either a fixed or variable interest rate. A fixed interest rate remains constant for the duration of your loan, providing predictability in repayments. On the other hand, a variable interest rate can rise or fall over the loan term, affecting your repayment amounts. Some lenders might propose a tempting lower introductory rate for certain loans, but it’s crucial to ensure you can afford the payments once the regular, often higher, interest rate kicks in.
Personal Loans and Lines of Credit
Personal loans and lines of credit are popular financing options due to their flexibility and ease of access. However, if you have a variable interest rate on your personal loan or line of credit, it can cause issues when interest rates rise. Let’s look at an example.
Brenda’s Personal Loan
Take, for instance, Brenda, a school teacher living in Calgary, Alberta. Brenda has a personal loan of $12,000, which she obtained at a variable interest rate of 15.49% with a 2-year repayment plan. However, with a potential rise in interest rates by 4%, her financial obligations would significantly increase. This rate increase would translate into an additional $23.12 per month on her loan payment. At first glance, this might appear as a small increase. However, when calculated over the 2-year term of her loan, Brenda would end up paying an extra $543.63 in interest. Therefore, a surge in interest rates can profoundly impact people like Brenda, placing additional financial strains on her budget, and potentially leading to the need for financial adjustments or the learning of frugal habits.
Questions To Ask Your Lender
Before taking out a personal loan or line of credit, remember to ask your lender the following questions:
- What is the interest rate?
- Is the interest rate fixed or variable?
- How would an increase in interest rates impact my monthly payments?
- Is there a cap on the variable interest rate to protect me from a significant hike?
Interest Rates and Mortgages
Mortgages can be significantly impacted by rising interest rates, as highlighted by the new guidelines protecting at-risk mortgage borrowers in Alberta. It’s vital to understand that while a fixed rate mortgage safeguards you from immediate changes, your payments could increase at the time of renewal or refinancing. On the other hand, a variable rate mortgage increases along with the interest rates.
Robert’s Variable Rate Mortgage
Let’s look at the case of Robert, a software engineer in Edmonton, Alberta. Robert is currently servicing a $350,000 mortgage on his home, obtained with a variable interest rate and set on a 25-year amortization schedule. The interest rate on his mortgage was initially 3.2%, which set his monthly payments at $1,692. However, a change in the economic climate leads to a rise in interest rates, taking Robert’s rate up to 5.9%. Consequently, his monthly mortgage payment increases to $2,218. This interest rate surge means Robert’s expenses go up by $526 each month. Over the course of a year, this adjustment leads to an extra $6,312 in mortgage payments. For individuals like Robert, an increase in interest rates can result in a substantial financial burden, which may necessitate a significant reassessment of their budget and spending habits.
Questions To Ask Your Lender
Before taking out a mortgage, remember to ask your mortgage provider the following questions:
- When does a variable rate mortgage make more sense?
- How can I assess my risk tolerance?
- What is the best mortgage option if I have a low risk tolerance?
- How does the frequency of payments affect my mortgage term?
- Is there anything in the contract that lets me pay the mortgage faster?
- Should I purchase a home at the maximum approved mortgage amount or aim for less?
When considering taking out a car loan in Alberta, there are several important factors to think about. Securing a car loan is a serious financial commitment and requires careful thought and planning. Beyond just the type and cost of the vehicle you desire, it’s vital to consider factors like the loan term length, interest rates, and your monthly repayment capacity. It’s also important to assess your own credit score, as it can significantly influence the terms of the loan you can secure. Remember, buying a car should not jeopardize your overall financial health. Also, keep in mind that changing the terms of a car loan is notoriously difficult. Be sure to thoroughly weigh your options to get the best rate possible before signing any agreements.
David’s Car Loan vs Jenny’s Car Loan
Let’s look at how the timing of taking out a car loan can affect the cost due to differing interest rates at different times, through the experiences of two individuals – David and Jenny.
David, a firefighter from Red Deer, Alberta, bought a new car in July 2020. He financed his purchase with a $25,000 car loan, locked in at a fixed interest rate for a 5-year term. At this time, the Bank of Canada had dropped the interest rate to a mere 0.25%. Consequently, David managed to secure his loan at the prime rate of 2.45%, leading to monthly payments of about $443. In total, over the loan’s lifespan, David would pay around $1,587 in interest.
Fast forward three years to July 2023. Due to rising inflation, the Bank of Canada has hiked the interest rates to 5%, pushing the prime rate to 7.2%. Let’s now look at Jenny, a social worker in Fort McMurray, who decides to buy a car that costs about the same as David’s. Because of the substantial rise in interest rates, if Jenny took the same $25,000 loan for five years like David, her monthly payments would come out to be $497.39. The total interest she would pay over the loan’s term would be a staggering $4,843.
The extra $54.39 in monthly payments may seem small. However, over five years, Jenny ends up paying over $3,000 more in interest than David, for the same car loan amount. This situation illustrates how shifts in interest rates can dramatically affect the cost of loans taken out at different periods. Therefore, it is crucial to be aware of the economic environment and the ongoing fluctuations in interest rates before committing to a loan.
Questions To Ask Your Lender
Before taking out a car loan, consider asking the following questions:
- What is the interest rate of my car loan?
- Can I pay more towards my car loan to pay it off early?
- Can I refinance my car loan at a later date if interest rates change?
Student Loans and Student Lines of Credit
Significant changes have recently been made to the interest rates on student loans in Alberta and across Canada, which will help borrowers. As of July 1, 2023, the interest rates, both variable and fixed, on Alberta student loans have been reduced to align with the prime rate. This is a shift from the previous structure where the variable rate was the CIBC prime rate plus 1%, and the fixed rate was the CIBC prime rate plus 2%.
In parallel with these changes, the Canada Student Loans program enacted a landmark policy that permanently eliminates interest accumulation on all Canada student loans as of April 1, 2023. This change includes loans currently in repayment. However, students are still required to pay any interest that may have accrued on their Canada loans before this date. Understanding the changes to student loan borrowing and your finances is an important first step. Let’s understand how fluctuating interest rates can impact student loans through Amy’s story.
Amy’s Student Loan
Amy, studying nursing at the University of Alberta, took a $20,000 student loan with a variable interest rate in the fall of 2020. At that time, the interest rate was 3.45% (a prime rate of 2.45% plus an additional 1%). For a 5-year repayment term, this rate meant that Amy would need to pay about $357.46 each month, totalling to around $1,447.47 in interest over the period.
However, fast-forward to July 2023, the prime rate has risen to 7.2%. This change would have an effect on Amy’s loan. Her monthly repayments would now increase to $384.55, and her total interest payable would double, rising to $3,073.28.
Amy’s situation serves as a reminder of how rising prime rates can significantly influence the cost of paying back student loans. When the prime rate increases, the monthly payments and the total interest payable also increase. That’s why it’s essential for students like Amy to keep track of these changes and understand what it means for their financial situation.
Questions To Ask Your Lender
Perhaps think about asking the following questions before taking out a student loan:
- How will an increase in interest rates affect my monthly student loan payment?
- Are there provisions to switch to a fixed interest rate or a cap on the variable interest rate?
- Are there options to extend my repayment time frame?
How to Manage Rising Interest Rates and Debt
The prospect of rising interest rates can be daunting and stressful, especially when you’re managing debt. However, there are several strategies that can help you effectively handle this situation and reduce financial stress. Here’s a roadmap to handling increased interest rates:
- Prioritize Debt Reduction
- Trim Your Budget
- Target High-Interest Debt First
- Consider Debt Consolidation
- Borrow Wisely
- Avoid Unnecessary Debt
- Avoid Additional Borrowing
- Find Additional Income Streams
- Establish an Emergency Fund
The most crucial step in handling a rise in interest rates is to focus on reducing your debt as much as possible. The less debt you have, the quicker you can pay it off, shielding you from the financial strain of larger loan payments due to increased rates. Need help? Try our Debt Repayment Calculator.
Choosing what debt to pay off first is vitally important. Focus on repaying the debt that has the highest interest rate first. This method, often referred to as the ‘avalanche method,’ allows you to pay less interest over the lifespan of your loan.
If you have several high-interest debts like credit cards, consolidating them into a single loan with a lower interest rate can be a wise move. However, always ensure that the terms of the consolidation loan are beneficial to you in the long run. Money Mentors offers a debt consolidation program with a fixed interest rate of 5% called the Orderly Payment of Debts (OPD) program.
Just because a lender offers you a maximum mortgage or line of credit, doesn’t mean you have to take it all. Borrow only what you need and can realistically pay back to prevent the accumulation of unnecessary debt. If you are considering a payday loan, make sure you weigh the pros and cons, and research alternatives to payday loans.
Resist the temptation of borrowing for non-essential items or experiences. If it’s something you want but don’t need, it’s better to save up for it rather than adding to your debt and experiencing buyer’s remorse.
Be mindful not to borrow more money than necessary, as it could hinder your ability to save for your goals. Remember, more debt equals more interest, which can take a bite out of your future savings.
Look for ways to increase your income, whether it’s through a part-time job, freelancing, or selling unneeded items. The extra income can be a significant boost in paying down your debt.
Life can throw curveballs, and having an emergency fund can help you deal with unexpected expenses. This is especially important when dealing with higher loan payments to avoid penalties or damaging your credit score.
Remember, rising interest rates don’t have to spell disaster. With a little foresight and practical financial management, you can effectively navigate this situation. Stay informed, make a plan, and keep your financial goals in sight.
Tried Everything, Now What?
As Albertans, we are no strangers to adversity, and in the face of rising interest rates, our grit and determination will serve us well. Despite our best efforts, if financial struggles persist, remember, there is always a way forward. Our unbiased certified credit counselors stand ready to provide debt help and support tailored to your unique situation. It’s never a sign of defeat to ask for help, but rather a brave step towards regaining control over your financial future. Together, we can weather this storm. Stay strong, Alberta.
Frequently Asked Questions
If interest rates go up, will my mortgage payments do the same?
Not necessarily. If you have a mortgage under a fixed-rate, your payments won’t change. However, your payments may increase when you renew your mortgage. Be proactive and meet with your lender 6 months before your mortgage is up for renewal to explore options. For mortgages on a variable rate, payments will go up when the interest rate goes up.
How do higher interest rates affect my loans?
If interest rates go up, the amount of interest you pay also increases if your loan is at a variable rate. This means larger payments and may require a stricter budget.
What happens in Canada when interest rates increase?
When the national policy rate goes up, lending rates from banks follow suit, effectively making it more costly to borrow. This discourages people from taking out new loans, whether for homes, cars, personal expenses, or businesses, which in turn leads to a decrease in demand for these sectors.