The Bank of Canada speculated about raising interest rates . This is not very surprising, since interest rates in the US have been higher than Canada for years. I was curious if that meant their CDs (their version of our GICs) paid a higher interest rate, but they don’t. Here are a couple things that might happen with rising interest rates.
Higher cost of borrowing — As interest rates rise, costs of borrowing rise. It will be more expensive to get a mortgage, to get a personal loan or to get a business loan. Many loans are based on a spread above prime, such as a variable mortgage at “prime + 0.5%”. When prime moves from 2.7% to something higher, the variable mortgage (or other variable loan) rate increases immediately. This could increase loan payment requirements or extend loan repayment timelines for consumers and businesses.
Lower bond prices — When interest rates rise, bond values fall. If the Bank of Canada raises rates, investors will likely require a higher yield on bonds that they buy. In order to get a higher yield on bonds, which pay a steady coupon, investors will offer a lower price. This will likely affect existing investments in bonds as well as ETFs and mutual funds that hold bonds. Preferred shares are also affected the same way — their yield will increase through a falling market price.
Higher mortgage cost and lower house prices — Rising interest rates may not affect the majority of existing mortgages, which are often at a fixed rate, but mortgages for a new house purchase (as well as renewals) will be at a higher rate. Because of higher interest costs, buyers will be faced with larger monthly payments for the same size mortgage. More likely, they’ll be able to afford a smaller mortgage for the same monthly payment. This might be good news for Vancouver and Toronto.
Higher financial company profits — When interest rates are really low, banks and other financial companies can’t charge a very large spread between deposits (such as GICs) and loans (such as mortgages). As interest rates rise, lending rates will (likely) rise faster than deposit rates, and spreads could increase, producing greater profitability for financial companies.
Stronger Canadian dollar — A higher interest rate should increase the demand of foreigners to buy Canadian dollars, to purchase Canadian-denominated bonds. It could also decrease the likelihood of Canadians converting their cash into other currencies to earn a better interest rate.
Reduced economic activity — Increasing interest rates will also cause business costs to rise for companies that borrow to fund their operations, which is most of them. More highly-leveraged companies (seen in the debt-to-equity ratio or the Dupont model financial leverage) will experience greater effects. Think of the example of a landlord where the tenant’s rent covers the mortgage payment. Now, with mortgage rates increasing, landlords have to decide to either raise the rent or to stop renting. Construction projects could be impacted in a similar way.