Who wins and who loses when the interest rates increase? It’s certainly not such a bad thing for real estate investors………

Posted on 11. May, 2010 by in General

Terry Mcbride, For Canwest News Service Published: Monday, May 10, 2010

An interest rate hike is good news for some people. For most Canadians, it’s bad news.

Helps some retirees

If you are retired and rely on income from Guaranteed Investment Certificates (GICs) and bonds, rising interest rates are good news. Weary of the meagre returns from GICs with rates as low 2%, you will probably want interest rates to go higher. Your lifestyle should improve thanks to increased cash flow once your GICs renew at higher interest rates.

If you are a retiree who transferred your employer pension account to a Prescribed RRIF or Life Income Fund (LIF), you might begin to consider converting to a life annuity with fixed monthly payments. Suppose interest rates spike. Should you convert some or all of your PRIF/LIF to an annuity at the peak to lock in relatively high rates?

Hurts borrowers

For borrowers, on the other hand, an interest rate hike is bad news – especially with consumer debt at record high levels in Canada. The average household owes $96,000.

Do you have a variable rate mortgage, home equity line of credit or a short-term mortgage coming up for renewal? You would have to tighten your belt to afford higher monthly payments due to rising interest rates. Cutting expenses is hard if you are living from paycheque to paycheque. Hopefully you have an emergency fund to help you cope.

Mortgage borrowers who have locked in low interest rates for five years, for example, are protected from rising rates – for a while.

Anyone using borrowed money to invest could see their profit margins shrink. They may decide to liquidate investments to pay down debt. If too many investors unwind their debts at the same time, the stock market indices can take a tumble.

Landlords who borrowed to invest in rental properties may need to raise their rents to cover higher mortgage interest costs. If a landlord has a big mortgage, those renters may be just as vulnerable as new home buyers to the rising cost of servicing debt.

If you made a family loan with a 1% interest rate during the past year, you are lucky. You can keep that extremely low loan interest rate in place indefinitely.

Bond prices drop

Bond investors would see the price of their marketable bonds and bond funds drop. In general, whenever interest rates jump, the value of bonds, particularly long term bonds, decline as a result. Indeed, almost any income-oriented investment such as an income trust or preferred share can also drop in value when interest rates climb.

To minimize their risks, bond investors can diversify by bond duration. They can buy a ladder of bonds. For instance, you could have one-fifth of your bond portfolio maturing in one year; one-fifth in two years; one-fifth in three years and so on.

When the shortest term bonds mature, the proceeds can, in turn, be reinvested for five years. When bonds have staggered maturities rolling into new bonds each year, you have less risk than someone who has all their bonds coming due at once. Diversifying by duration helps you cope with the risk of rate fluctuations.

Bond Exchange Traded Funds (ETFs) provide another easy way to hold a diversified bond portfolio.

Be debt-free

Becoming debt-free is the best way to make yourself less vulnerable to interest rate hikes. Start paying down debts with the highest interest rates, such as credit cards and unsecured personal loans.

Postpone the purchase of a new home or new car until you have saved enough money to keep your loan payments to an easily manageable level, despite interest rate hikes.

If you aim to retire soon, become debt-free. You will be much more financially secure as a lender earning interest rather than a borrower paying interest.

Terry McBride is a member of Advocis (The Financial Advisors Association of Canada). This article provides general information and should not be considered personal investment or tax planning advice.

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