How High Interests Rates Can Help Ordinary People

With low unemployment and an economy operating at near capacity, the Bank of Canada recently made a decision to increase it overnight lending interest rate to 1.25%.

Arguments could be made that incremental rate hikes at this time could derail the Canadian economy. There are legitimate fears: the looming uncertainty with NAFTA; the potential loss of business investment due to a more appealing tax environment in the U.S., elevated levels of personal debt, flat oil prices, stricter mortgage guidelines, etc.

Few people actually want higher rates, whether instituted by the Bank of Canada or the government, as this article in the Financial Post argues:

Beginning Jan. 1, families getting mortgages with down payments over 20 per cent must prove they could pay a theoretical interest rate that is two percentage points higher than what they actually negotiated with their lenders. When actual rates go up — as they did last week — this imaginary “stress test” rate automatically goes up too, so it’s always two points higher. For practical purposes, homebuyers just saw their purchasing power slashed by about 20 cents on the dollar.

This makes sense: nobody wants to hand over increasingly higher sums of their money to service debt. Debt is fun when cheap, but a burden when expensive.

Though rarely discussed by financial pundits, higher interest rate can actually prove to be beneficial to the average person: higher rates favour less riskier investments – and that’s a good thing.

In an economy marked by low interest rates, people are forced to take on a great deal of risk when it comes to the allocation of their money. This is due to the meager returns offered on traditionally less risky investments, such as GICs and bonds. These asset classes typically offer less than stellar returns when compared with stocks and real estate. They may even prove inadequate in protecting the purchasing power of the investment portfolio from being eroded by inflation.

Low interest rates leave people little choice but to place their money in speculative investments, in order to grow their portfolio. This should be unnecessary; passive investing in high grade fixed income instruments should suffice (with perhaps some percentage invested in blue chips stocks, preferably ones that pay dividends). With all the hardships, struggles, and challenges of life, an individual’s investment portfolio should not unduly contribute to  stress and anxiety.

Low interest rates allow for the accumulation of risky assets – and with them the exorbitant returns. The cheap money causes various asset classes to surge, providing the fuel for bubbles – and their eventual pop. When financial markets crash they can easily eviscerate investment portfolios, much to the shock and dismay of starry-eyed investors.

The average person doesn’t understand that the stock market is much more riskier than financial planners and economists make it out to be. The stock market does not generate returns the way investment theorists propound. So called “medium risk” portfolios are actually over priced, due to the hidden risk they carry (most funds will not produce the returns investment representatives at banks say they will). Most people underestimate the losses incurred when markets crash and the amount of time it takes to rebuild the lost wealth.

The average person can’t answer basic questions about money. They are easy prey for mutual fund salespeople and investment portfolio managers who don’t correctly or honestly explain the risk they are embracing when they invest their money (though there are excellent portfolio managers and financial planners out there who do know how to provide guidance, and do what’s in their best interest of the client).

High interest rates exact discipline by encouraging people to invest in less risky assets that offer more safety and predictability; most people shouldn’t engage in reckless speculation. An economy characterized by low interest rates forces everyone to become a speculator – even if they don’t want to.

Unfortunately, we have had about ten years of record low rates. The younger group of Canadians has grown up accustomed to paying minuscule amounts of interest on their mortgages, student loans, auto loans, and just about every other kind of loan. It will be interesting to see how they’ll adjust if rates continue to creep higher.

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