Lower interest rates bring relief to borrowers, but that’s not really the point.
What the Bank of Canada is saying when it lowers its benchmark rate is something along the lines of “Get to it – spend!”
Lower rates make it less appealing to hold money in savings and more economical to borrow money to spend, invest and buy homes. The problem with low rates is that they’re kind of like a drug that impairs your judgment. People overdo it in ways that include:
Getting overamped about housing
Lower rates ostensibly make housing more affordable by making it cheaper to finance a mortgage. But then more buyers enter the market, which means more competition for good properties. And then the fear of missing out takes hold, which leads to bidding wars, with people overpaying to get what they imagine they want.
Housing is appealingly calm right now – prices are edging higher, if at all, and mortgage rates have come down nicely from their recent peak. The economic fundamentals don’t exactly scream “housing rally,” given this year’s rise in unemployment and slow growth. But cheap money will eventually spark the market again.
Relying too much on dividend stocks
Money has been pouring into many previously shunned dividend stocks because competing returns from bonds and guaranteed investment certificates have fallen. Dividend stocks are an excellent source of tax-advantaged income in non-registered accounts, and dividend growth is an ideal answer to inflation. But dividend stocks are, well, stocks. And that means risk.
When the next stock market correction happens, dividend stocks will not be spared. Dividends will flow as usual, unless the company paying them is in financial distress. But share prices will fall in a way that disturbs people who have enjoyed the risk-free returns of GICs over the past couple of years.
Borrowing to invest
If you’re going to borrow to invest, either through a line of credit or a margin account with your broker, the time to do it is after a market crash has created a buying opportunity. But most people shouldn’t do it at all, even if the cost of borrowing falls below a reasonable projected rate of return. There’s simply too much stress in owing money on volatile investments. If there’s a big drop in price, you’ll be tempted to sell at the wrong time. You’ll end up paying interest on a money-losing investment.
Using lines of credit like a savings account
Interest rates on home equity lines of credit, a.k.a. HELOCs, are still high compared with the pre-pandemic norm. But each rate cut by the Bank of Canada means an identical drop in the cost of carrying a balance on a line of credit. As credit lines get cheaper, it’s more tempting to use them as a supplement to regular income and to cover big expenses.
If you own a home, you should definitely have a HELOC in your pocket to take advantage of the interest rate, which will almost invariably be lower than those of unsecured credit lines and consumer loans. But HELOCs should be used to borrow strictly for the short term – say, 12 to 24 months.
Repeatedly dipping into a HELOC can lead to “perma-debt.” You have to make a minimum payment each month with HELOCs, but that only covers the interest.
Buying too much car
A lot of vehicle buyers gauge affordability based on the monthly payment. If interest rates offered by dealers fall, and this is starting to happen, that means they can afford more vehicle. Here’s the problem with that thinking: people are already spending excessively on new cars, SUVs and trucks. The average vehicle loan payment at midyear was around $880 per month, according to J.D. Power. Worse, 56 per cent of new vehicle loans had terms of seven years or more, which is a long time to be paying off a fast-depreciating asset.
Buying a new vehicle is a fine thing to do because it helps support the economy. But the amounts people spend eat up a lot of household income. Falling rates would support this trend.
Questioning whether it’s worthwhile keeping money in savings
Expect the latest rate cut by the Bank of Canada to be felt in the returns offered on savings accounts from alternative banks that offer better rates than the big banks. Falling rates on savings do erode the rewards of keeping money safely parked for emergencies or near-term expenses. But the true benefit of savings is having zero-risk money you can count on if you need it.
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