Is the long-awaited drop in interest rates a cause for celebration?

After much anticipation, the Bank of Canada finally took a first step towards lower interest rates on June 5th, 2024 when they reduced their policy rate by 25 basis points from where they have been stuck for the past 11 months.

Interest rate adjustments

The primary purpose behind interest rate adjustments is to keep inflation at its targeted rate of 2%. Inflation measures the purchasing power of your money. In other words, how much more do you have to pay today to buy the same goods you would have bought before for less money. The more expensive goods are now, the higher the rate of inflation.

By reducing interest rates, the Bank of Canada is saying that inflation is getting closer to the 2% target. This is good news for consumers who bear the brunt of higher-priced goods and services. But it only means the cost of goods is not rising as quickly as it has been since 2021. It does nothing to compensate for the dramatic increase in prices Canadians have experienced during that time. Goods today are 14.47% higher on average than they were in 2021, and because of inflation, that cost continues to rise every year.

How interest rate policy affects you

The effect that a decrease in interest rates will have on you will depend on your situation. Fixed-rate loans, like many mortgages, as well as most car loans and credit cards, will largely be unaffected because the interest rates are already locked in. But if you have a variable rate loan, or if you’re looking to take on new debt, the cost of borrowing money will be less.

The most common variable-rate loans for consumers include variable rate mortgages and lines of credit. For a person with a $400,000 mortgage over 25 years, a 0.25% reduction in interest rates would equate to roughly $977 in savings over 1 year, or approximately $81 per month. Relative to the required monthly payments on that mortgage, $81 may not seem like a cause to celebrate but if interest rates continue to fall, each subsequent 25-point reduction will provide a further $81 savings per month.

It seems likely that for the average consumer with variable rate debt or looking to take on new debt, the benefits of a lower interest rate won’t be too noticeable until rates drop a further 50 to 100 basis-points (or 0.5% – 1.0%).

Is this the first of many rate cuts?

Many economists predict that rates will continue to decrease in 2024. What the Bank of Canada says is that, “they have increased confidence that inflation will continue moving closer to 2% but the risks to inflation remain”. The next rate announcement is scheduled for July 24, 2024, so stay tuned!

Can you take advantage of the drop in interest rates?

This sounds like an easy question but it depends on your current situation and what you expect to happen in the future. If interest rates continue to drop, you could save more by waiting to take on a new loan or renewing an existing one. On the other hand, if you expect interest rates to hold or increase again — which they may if the decrease in interest rates leads to higher consumer spending — you could benefit from locking in now at the lower rate while it lasts.

The risk in making decisions based on trying to predict future interest rates is that you have no control over the outcome. It’s a bit of a gamble. A safer approach is to make decisions based on the information you know: the current interest rate and your current situation.

For those already in a mortgage or other loan with a lower interest rate, this is an opportunity to take the “savings” from a lower interest rate to pay those debts or (other higher interest rate debts) down faster. And for those who may have a mortgage or other loan coming up for renewal, you may have to choose between a variable or fixed rate. It may be tempting to choose a variable rate mortgage if you predict that interest rates will drop. And if you are right, you could save a considerable amount of money. However, if you cannot afford the risk of interest rates going up, then a fixed rate may still be the safer option.

Balancing debt with the high cost of goods and services

While the drop in interest rates will offer some people an opportunity to save money by reducing the cost of borrowing, the reality is many people may receive little or no benefit. And they will still be left to continue bearing the higher cost of goods and services. This can make paying off debt feel difficult or impossible. If you are struggling to juggle both your debt and the rising cost of living, reach out to MNP to explore your options.