Impacts of rising interest rates on unsecured debt and financial health

The Bank of Canada (BoC) increased its policy interest rate by a full percentage point on July 13, 2022. It was the fourth increase to the overnight rate this year and the largest since 1998.

Canada’s overnight rate was 0.25 percent at the start of 2022. Following is a snapshot of how it has trended through four increases between January and July:

What is the overnight rate, and what do higher interest rates mean for Canadians?

The BoC overnight rate is what central banks theoretically charge domestic financial institutions to borrow money. Commercial banks typically use this benchmark to guide their lending rates. It also influences the return on savings accounts and certain investment vehicles such as Guaranteed Income Certificates (GICs).

Some households welcome increased interest rates as a historically rare opportunity to earn income on their surplus cash. Many are anxious about higher borrowing costs and difficulties servicing their debt.

There is a general understanding that every increase will make it harder to pay down debt, and therefore cause consumers’ financial health to deteriorate. However, the impacts of rising interest rates will depend on several factors, including:

• Type of debt
• Amount of debt
• Debt serviceability

Type of debt

As the BoC increases interest rates, lenders will often pass these costs on to consumers.

The type of loan will generally dictate the borrowing cost; the riskier the loan the higher the rate. Lending products such as lines of credit, finance loans, and mortgages are all tied to the BoC rate. These are the sources of financing where consumers are most likely to see the cost of borrowing go up.

Other forms of unsecured debt such as credit cards and personal loans won’t see those same effects in the short term. This is because their interest rates are already high and several steps removed from the BoC rate.

Amount of debt

The larger the debt load, the larger the monthly payments. The larger the monthly payments, the more they will increase (in dollar value) as interest rates rise — less of which will contribute to the principal value of the debt.

Households with large or numerous debts tied to the BoC rate will want to review their finances to understand how recent interest rate increases impact monthly costs. They may consider cutting back on non-essential spending or speaking with a Licensed Insolvency Trustee to discuss options for debt relief.

Debt serviceability

It’s possible to offset the effects of higher interest rates by paying down the principal, which reduces the amount accruing interest. However, this is often easier said than done.

Not only are households limited by their monthly earnings potential, but inflation has also increased the cost of consumer goods and services by upwards of eight percent over the previous year. Certain expenses like fuel and food have increased even more.

Ironically, interest rates are the BoC’s primary tool to control runaway inflation. That means Canadians will ideally see the cost of goods stabilize in the medium term. However, they will have to find a way to absorb a sharp increase in their expenses for the foreseeable future.

How can you respond to higher interest rates?

1. Debt avalanche

Make a list of all your debts and their interest rates. Note any debts connected to the overnight rate such as mortgages and lines of credit — as well as any renewal dates. Focus on paying down those debts with higher interest rates to minimize the impacts of rising borrowing costs.

2. Budget

Review your household budget and note how your debt costs and expenses have increased. Adjust your spending where possible.

This may require reducing your discretionary spending (e.g., dining out, shopping, entertainment, etc.) and supplementing existing sources of income. Be sure to include a provision for unexpected events and those that occur less frequently.

3. Be proactive
   

   If you have a mortgage coming up for renewal, start investigating what you may be facing. The larger the mortgage, the higher interest rates will impact the monthly payment. This could influence how much a lender is willing to finance.

4. Contact a Licensed Insolvency Trustee

Schedule a Free Confidential Consultation with MNP to review your financial situation to discuss your debt relief options. The trustee will walk you through all the solutions available (e.g., consolidation, credit counseling, a Consumer Proposal, and Bankruptcy). They will also provide an unbiased opinion on which would work best for your unique circumstances.