Posted by: Don Bayer, CFP
At some point each year I have a lively interest rate conversation with my uncle that always ends with a familiar line that sounds something like this, “ …but have you forgot when interest rates were 20%? It could happen again!
Now I love drama like anyone else but he always made it sound like those were long, tough days, etched in his memory and that we all suffered long-term psychological affects as a result of these interest rates.
The truth of the matter is that if you look back over the years, these incredibly high interest rates lasted only a few months before rapidly decreasing to more regular interest rate levels. Inflation was the culprit behind the interest rate activity then, hovering in the 12% range for most of the early 1980’s, a far cry from today’s rates. However, while interest rates were at these levels for only a few months, many individuals panicked and locked in to long term contracts, only to see interest rates fall in the following year – dramatically.
Let’s take a moment to better understand how inflation can affect interest rates in Canada. First off, the term “core inflation rate”, is likely one of the most misunderstood economic terms that is used by governments around the world.
The core rate measures the price change in products and services that we purchase in our lives and excludes many items which have volatile price movements (energy and food products). Many of these volatile products are items a normal family buys each month. Governments control our spending behaviour by manipulating interest rates; when inflation is low, we can maintain low interest rates. Low interest rates encourage consumers to spend which, in turn, should stimulate the overall economy.
Inflation affects people differently depending on where you live and what you buy!
I suggest to people that they measure their own inflation rates based on the products and services that you buy. For example, buying a home in Toronto became more expensive in 2008 due to the land transfer tax, but this new tax may not apply to someone living outside of Toronto. Likewise, when the harmonized sales tax (which sounds peaceful and serene) was passed, it added an additional tax of 8% to all new homes over $400,000 in the province of Ontario. This increase in price only affects residents in Ontario. The point is that where we live and how we live always dictates our personal inflation rate.
Over the past decade, we have witnessed large movements in interest rates and we have learned not to panic and make quick, short term decisions. From 1990 to 2004, interest rates decreased from a high of 12% to a low of 3.5%. Since 2004, rates again moved higher to 6.25%, only to fall back again the following year. The long term trend would suggest that Canada has wrestled inflation to the ground which brought affordability to the market for the past 8 years and has fuelled tremendous growth in real estate values. We now are painfully aware that there were many other interesting factors at work that artificially fuelled almost every aspect of our economy. But interest rates have actually decreased. When you really think about it, we have got ourselves into so much hot water that we cannot increase rates in fear of stopping what little economy we have going. Amazing!
Our advice in this interest rate market is to stay calm and move away from sharp objects. Is now the time to lock into a long term mortgage contract? Does a 4.0% five year interest rate look pretty tantalizing? Well, how does a 3.0% interest rate sound? As long as our largest trading partner is having problems, rates will remain low to stimulate our economies. Don’t get me wrong, every economist and business leader in the world anticipates that once the government stimulus begins to work its way through the system, interest rates will rise to combat price pressure but until then, now is a great time to simply pay down your mortgage.
The good news for Canadians is that the prime rate in Canada will likely decrease again in the following months. Whether it moves to 0.00% like it has in the U.S., only time will tell but this makes mortgages extraordinarily inexpensive in this country. MonsterMortgage.ca has been educating our clients for years on the benefits of choosing a variable rate mortgage over a fixed product. The fact is that the prime rate in Canada has maintained a 3% band for the past 9 years. We do recognize that there is a comfort in knowing what your mortgage payment is each month and volatility is often associated with variable rate mortgages. At the end of the day, seek advice from a qualified mortgage agent who represents the entire marketplace and has access to many different products and mortgage solutions. At the end of the day, the best lesson I have learned is that it is easier and less expensive to pay off your mortgage when interest rates are low. Now is your opportunity to start contributing to your bottom line and not your bank’s.