Rising Interest Rates

What You Should Know

August 10, 2017

Three key potential consequences of rising interest rates:

  1. On homeownership and household debt
  2. On savings
  3. On the cost of borrowing

As you may know, The Bank of Canada has raised the interest rate for the first time in seven years by 0.25%, from 0.5% to 0.75%. The increase in the interest rate will have effects on various stakeholders in the Canadian economy, including consumers and businesses.

As usual, CIBC Deputy Chief Economist Benjamin Tal was quick off the mark with an assessment of the impact of this move, notably on homeowners. In an issue of In Focus (July 19, 2017) entitled Assessing Household Debt’s Sensitivity to Higher Interest Rates, Mr. Tal drew the following general conclusion.

Consumer spending to soften due to increased debt payments

Wrote Mr. Tal: ‘Headline numbers clearly don’t tell the whole story. To get a full understanding of the impact of higher rates we also have to visit the margins of the debt market spectrum. We conclude that those margins are not wide enough to generate a wave of defaults following the Bank’s expected tightening. Consumer spending is likely to soften due to increased debt payments, while the pace of growth in mortgage outstanding is expected to cool notably as the impact of higher rates is amplified by the expected changes to qualifying rate criteria on the non-insured segment of the market.’

An increase in mortgage rates

The higher interest rate may lead to an increase in mortgage rates. This will make it more expensive and, consequently, more difficult for existing homeowners to pay their mortgages. When existing homeowners struggle to pay off their mortgage, it may even push some towards foreclosures. Also, the higher mortgage rate may cause prospective entrants to delay their house purchases. This may lead to less demand for real estate, which may have a dampening effect on high real estate prices. This will reduce the possibility of the creation of real estate bubbles or dampen an existing one.

An incentive to save

The increase in the interest rate will provide greater incentive to Canadians to save more. The higher interest rate will lead to higher income for depositors in banks. However, with an increase in interest rate of only 0.25%, the effect on savings is expected to be quite limited.

The cost of borrowing

The higher interest rate will increase the cost of borrowing. This may make Canadian businesses less enthusiastic to borrow to invest or expand their businesses. The higher cost of borrowing will increase the cost of production of goods and services. If businesses decide to pass on this higher cost to consumers, it will lead to higher prices. This will increase the cost of living and may even contribute to inflationary pressures.

Higher prices of goods and services may make Canadian exports less competitive in export destinations. Imported goods and services to Canada will be cheaper relative to domestically manufactured goods and services, which may make them more appealing to Canadian consumers. However, the possible effect on the prices of goods and services due to a 0.25% in interest rates is predicted to be quite insignificant.

The bottom line

When interest rates rise, four things typically happen:

  1. Borrowing becomes more expensive
  2. Deposits yield more
  3. The stock market gets jittery
  4. The dollar strengthens

To learn more, contact Michael Fahy, The Michael Fahy Group, CIBC Wood Gundy, at 604 691-7207.