Rounding it up
An interest rate is a percentage fee that banks charge for the service of lending you money.
The Bank of Canada sets a target rate that banks should use to lend to one another; this is how it can influence interest rates based on global conditions.
Rising interest rates mean getting into financial stocks, buying on credit soon to lock in low rates, and keeping calm.
Interest rates affect everything in our modern economy, from your mortgage to your credit card to your qualified retirement accounts. Even though they’re an ever-present part of our lives, we often don’t think too much about interest rates. Sure, you may know about them as they relate to your credit card or mortgage but you might not have a clear picture of the broader interest rates that underpin those financial mechanisms.
The Canadian economy, along with much of the rest of the world, has been in a low-interest-rate environment for the last several years, primarily driven by the need for the government to support individuals. However, rates can’t remain low forever. What should you be thinking about as interest rates begin to rise? What assets should be in your portfolio? Let's read on to learn more about the different types of assets that perform well as interest rates rise.
What is an interest rate?
Put simply, an interest rate is the amount of money you have to pay to your lender in order to borrow their money. Generally speaking, an interest rate is expressed as a percentage of the amount of the principal that you owe over a period of time. This period of time is usually marked as an Annual Percentage Rate or APR. The length of your loan as well as the amount of money you borrow will drastically affect the interest rate. For example, if you borrow a large amount of money over a long period of time, like with your mortgage for example, your interest rate will be lower as compared to borrowing over a short period of time, like with your credit card.
Your credit report and score will also affect the kind of interest rate you can get for a variety of different products. If your credit score is low, you have to pay more to access funds (i.e. a higher interest rate). This is because the lender is attempting to compensate for the risk they take when lending to you. If you’ve got a higher credit score, you can expect more favourable interest rates.
But this isn’t the same type of interest rate right?
It's not, but it is closely related. The interest rate we’re talking about in this article really has to do with the broader interest rate that is charged to banks who borrow money from the Bank of Canada. The central bank determines the base rate at which it will lend money to banks. This is called the policy interest rate and it is currently set at .25%. This is sometimes called the overnight rate because it is the rate at which banks borrow and lend money with one another while they reconcile payments at the end of each day.
By raising or lowering this rate, the Bank of Canada is able to influence short-term interest rates because banks can charge less or more based upon the amount they can charge one another.
What’s the point?
The Bank of Canada does this for three key reasons. First, when the policy rate is lower, people pay lower rates on mortgages, car loans, and other instruments as we discussed above. When rates are low, people tend to spend more money because the return rate for saving money is much lower.
When the policy rate is higher, it discourages people from borrowing money because it costs more to do so. People also tend to save more because the return is higher. The Bank of Canada is able to control how fast the economy grows—and keep inflation at bay—by influencing this rate.
So which assets do well with rising and high rates?
In an environment like the one we’re currently living through, with historically low interest rates, it can be hard to keep in mind that eventually, they will have to start to rise again. As we emerge from the pandemic, rates will undoubtedly begin to rise. So what are a few assets you should consider when rates are nice and low? Let's read on.
Investing in financial institutions
A no-brainer here. Who benefits from borrowers paying higher rates? Financial institutions, of course. Certainly, they will have to pay more to borrow as well, so that cost will be passed on. However, financial institutions will want to capitalize on the rising rates, and so, profits will follow.
Buying on credit
It’s a good idea to lock in rates when they’re low if you’re planning on making any large purchases in the future. Thinking about a car? Maybe even a mortgage? As rates go up, credit gets more expensive. It’s a good idea to invest in anything you need to purchase using borrowed money now and lock in the rate.
In terms of investment, it's best to think about short-term investments. This is because when rates rise once, they tend to continue to do so for a sustained period. This means that your initial investment may not be worth as much as rates continue to rise. Long-term investments tend to weather higher rates poorly.
Companies that pay out high dividends have been shown to weather higher interest rate environments when compared to those companies that do not. Dividends are payments that a company gives back to shareholders out of its profits. Typically, larger companies pay dividends on stocks.
Is there anything I need to do to prepare?
If you want to take advantage of the coming higher rates, you need to be thinking about what you need to do now before they come. First, if you have a mortgage or home equity loan with an adjustable rate, consider refinancing it into a loan that has a fixed rate. Adjustable-rate mortgages and loans mean the rate will climb along with the broader interest rates, making your asset more expensive over the long term.
Second, If you’re planning a large purchase, like a home or a car, now is the time. While rates are up slightly given the current economic situation, as central banks raise rates, these types of instruments will only get more expensive.
Finally, don’t panic. The market and the economy tend to be highly cyclical. Higher rates will come and go just as the lower rate environment did. As long as you think carefully and plan appropriately, you’ll enter a higher rate period with the right assets to meet your financial goals.
Dan is a runner and writer living in the Washington, D.C. area, where he currently works for a financial services trade association as the Communications Director.