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Jason Heath: There is an advantage to higher interest rates

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An ultimate benefit is that borrowers have a more realistic monthly payment for their debts

The Bank of Canada in Ottawa. Photo by Justin Tang/Bloomberg files

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Interest rates have risen rapidly this year and with inflation exceeding the Bank of Canada target, more hikes are sure to follow. While much attention has been paid to the negative consequences of higher rates, which increase the cost of borrowing, there are also benefits.

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The first question on Canadians’ minds is how high interest rates will go, something central bank governor Tiff Macklem raised last week when he testified before the House of Commons Standing Committee on Finance.

According to Macklem, “Canadians should expect interest rates to continue rising toward more normal conditions…that neither stimulate nor tax the economy. We estimate this rate to be between two percent and three percent. Two weeks ago, we the key rate increased to one percent, still well below neutral.”

This suggests a neutral interest rate environment that is one to two percentage points higher than now. The primary rate at banks is 3.2 percent, so lines of credit and mortgage rates above five percent are achievable. This is a far cry from the rates of less than two percent that were available in 2021 – suddenly the implementation of the mortgage stress test in 2018 seems more cautious.

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An ultimate benefit of higher interest rates is that borrowers will have a more realistic monthly payment for their debts. Although the mortgage stress test qualified a borrower based on a higher interest rate, borrowers have become accustomed to artificially low monthly payments with little interest.

If a five-year mortgage depreciating at 2% over 25 years is extended by 5%, the payment would need to be increased by 30% to maintain the remaining 20-year amortization. To keep the monthly payment at the higher rate the same, the amortization would have to increase to over 34 years (i.e. over 39 years in total). Canada actually had 40-year insured mortgage write-offs for less than a year between 2007 and 2008, but promptly cut write-offs in response to the collapse of the U.S. subprime mortgage that triggered the financial crisis.

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Higher rates can put pressure on highly indebted borrowers in the short term, but over time they can also help recalibrate borrowers’ housing budgets based on actual monthly payments. This could also help stabilize the housing market, hopefully leading to a soft landing rather than a housing crash.

In addition to borrowing, higher rates have consequences for investments, pensions and retirement. In 2022, fixed income investors were burned or cashed in, depending on their product of choice. The FTSE Canada Universe Bond Index is down 9.6% to date on April 30. When interest rates rise, bonds fall, and when interest rates rise quickly, bonds fall quickly. This is because newly issued bonds with a higher yield are more attractive, so that previously issued bonds with a lower yield will fall in value. Meanwhile, GIC rates have surpassed levels not seen since 2010. Some institutions offer five-year rates in excess of four percent.

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Tiff Macklem, governor of the Bank of Canada, speaks at the Bank of Canada in Ottawa. Tiff Macklem, governor of the Bank of Canada, in Ottawa. Photo by Justin Tang/Bloomberg files

A four percent interest rate may not seem very attractive when inflation is at its 31-year high of 6.7 percent, implying negative real returns. However, the Bank of Canada expects inflation to return to 2.5 percent in the second half of 2023 and to its target of two percent by 2024. The point is that inflation, while more than just transient, is still temporary, but higher income returns are likely to stay here. In the coming years, this will be a good thing for conservative investors.

Higher rates also affect pension plans. Falling interest rates over the past 30 years have prompted pensions to invest in riskier assets to improve returns. In 1999, the Canada Pension Plan was even fully invested in government bonds. At the end of the year on March 31, 2021, only 23 percent of net assets were invested in fixed-income securities.

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There are greater benefits to pension plans and participants as rates get higher. The coverage ratio of a pension is influenced by the interest rates. Rates are used to value the future obligations of a pension plan, namely payments to participants. The presumption is that assets will be invested at current interest rates, so low interest rates mean that more assets must be set aside for paying pensions. As interest rates rise, pensions with deficits will see their funding status improve and other plans can fill their surplus.

Interest rates also affect retirees considering a lump-sum payment, called a surrendered value, when they terminate a retirement plan, as well as those considering a past-service buy-back.

Many pensions saw an increase in surrender value payments to pension participants who chose to invest their pension money themselves instead of receiving a future monthly payment. Some allowed huge tax bills on the taxable portion of their surrendered value and may have used retirement money earmarked for retirement for current expenses. Depending on how those payouts are invested in the future, they may or may not provide higher retirement income. Higher rates are likely to reduce the commutation of pensions.

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A retiree with a fixed pension payment is at risk of higher inflation, especially if they don't own stocks or real estate that can provide some hedge against higher prices.

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On the other hand, service buybacks are likely to increase. A participant in a pension plan may be eligible for a buy-back if he has taken leave, including maternity or paternity leave. Other scenarios include not joining an employer’s retirement plan or working for a related employer whose retirement plan was less lucrative.

In the same way that higher rates reduce current pension shortfalls or surrendered values, they also make it cheaper to buy back retirement services. This could provide an opportunity for plan participants to increase their retirement benefits by writing a check or transferring money from a tax-sheltered account such as an RRSP or a defined contribution plan (DC).

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Higher rates can also change the retirement income planning landscape by making annuities more attractive. When the prime rate rose to more than 20 percent in 1981, the demand for annuities surged in the 1970s and 1980s. However, due to the low interest rates of recent years, the demand for annuities has decreased significantly.

When a 65-year-old buys an annuity, it’s like buying a 25-year GIC. When interest rates are low, the expected return (monthly payment) is also low. As interest rates rise, retirees may find annuities more attractive. Non-retired people with retirement envy can buy a pension from an insurer in the form of an annuity. Annuities can simplify retirement income planning by capturing monthly payments and protecting retirees from the risk of living too long.

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Rates last started rising in 2018 before falling again at the start of the pandemic. They can be difficult to predict and can rise and fall with economic cycles, but given the Bank of Canada’s primary goal of controlling inflation and all the pressures driving prices up, continued increases seem quite likely. While higher rates have some negative consequences, good things will also come from rising interest rates.

Jason Heath is a board-certified financial planner (CFP) who pays only a fee and provides advice only at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell financial products at all.

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This post Jason Heath: There is an advantage to higher interest rates was original published at “https://financialpost.com/personal-finance/debt/jason-heath-theres-an-upside-to-higher-interest-rates-despite-the-pain-to-borrowers”

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