After the FED raised interest rates in the U.S., the Bank of Canada did the same. In July the central bank increased rates by 0.25%. This means the Prime lending rate at banks is now 0.25% more expensive for borrowers. What does this mean for Canadians in debt? It means we should reduce our debt balances to normalize our interest expenses and keep our debt load under control. 🙂
How to Adjust Debt Levels Based on Interest Rates
So if the interest rate is higher by 0.25% how much debt should we try to pay down? We can use the following formula to find out. 🙂
Debt amount to pay down = (Interest rate increase amount) x (total debt balance) ÷ (new interest rate on loan)
For example, let’s say I have a variable loan with $100,000 outstanding and my interest rate was 5% before the interest rate hike. So this loan was costing me $5,000 a year in interest payment. But the central bank raised rates by 0.25% so now the loan is costing me 5.25% or an extra $250 per year more than before. I want to know how I can lower my cost of borrowing back down to $5,000/year.
Debt amount to pay down = (0.25%) x ($100,000) / (5.25%)
Debt amount to pay down = $4,761
This means in order for my borrowing cost to stay at $5,000 per year, I will need to pay down $4,761 of my $100,000 debt balance. So at this point I have a decision to make. I can either pay down my debt quickly to bridge the $4,761 gap so I can go back to my initial budget. Or I can accept paying more interest (0.25% or $250 more) every year and work that extra cost into my budget.
Personally I like to adopt a combination of both. 🙂 Earlier this year I used half of my monthly savings to pay down debt, and the other half to invest. But after July’s rate hike I’m putting roughly 75% of savings into debt repayment, and 25% into new investments. Anyway, below are the results of my August finances.
Liquid’s Financial Update
*Side Incomes:
- Part-Time = $1100
- Freelance = $800
- Dividends = $600
- Interest = $300
- Fun = $300
- Debt Interest = $1200
*Net Worth: (ΔMoM)
- Assets: = $1,112,600 total (+900)
- Cash = $3,000 (+500)
- Canadian stocks = $148,500 (+2100)
- U.S. stocks = $90,400 (-1000)
- U.K. stocks = $19,700 (-200)
- RRSP = $82,400 (-700)
- Mortgage Funds = $31,500 (unch)
- Peer-to-Peer Lending = $21,300 (+200)
- SolarShare Bonds = $9,800
- Home = $270,000
- Farms = $436,000
- Debts: = $478,700 total (-2,900)
- Mortgage = $182,100 (-400)
- Farm Loans = $187,800 (-500)
- Margin Loans = $57,700 (-200)
- TD Line of Credit = $11,200 (-1200)
- CIBC Line of Credit = $24,000 (-500)
- HELOC = $15,900 (-100)
*Total Net Worth = $633,900 (+$3,800 / +0.6%)
All numbers above are in $CDN.
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Random Useless Fact
According to Wikipedia, Iceland does not have a standing army. But it is recognized as the world’s most peaceful country.
I really enjoyed your first section about adjusting for interest rates. That is a great tool to handle any risk adjustments that might be necessary.
I was wondering what the SolarShare Bonds are?
Thanks Money Brain. 🙂 The Solarshare bonds was this investment I purchased last year for $10,000. It basically returns 6% annually and pays investors twice a year. It’s amortized for 15 years though so it’s made for long term investors. I blogged about it here. https://www.freedomthirtyfiveblog.com/2016/10/how-to-make-money-from-the-sun-my-new-investment-in-solar-energy.html
Interesting. The bond just popped out at me personally, because I recently bought a bond for the first time. Thanks for the info.
Interesting article! Something that I haven’t thought about in terms of having a mathematical formula to it.
But I would agree that paying off your debts aggressively more than before is a good idea. At the same time, I don’t want to solely focus on debt repayment, and a combination of both works well.
Another simple way would be to always pay more than the minimum, and see how much principal is getting repaid to gauge the interest rate effect. This is more of a rough calculation!
Cheers
PAI
Another factor that goes into my decision making is the valuation of the stock market. If stocks are cheap relative to historic P/E ratios then I will more likely invest than pay down debt. 🙂
I like your prudent approach, doing a bit of both! Your fun discretionary spending is so low ($300), even in the summer?! What about all the food trucks and yummy places to eat in Vancouver? 😉
Haha, I’m a guy with simple needs. I got used to cooking at home so I rarely eat out. There’s also a lot of perks from my employer like free food sometimes, and a gym membership. I’m not a big fan of traveling either. If money wasn’t an issue I would probably spend my weekends staying at home and reading or playing games, like I’m doing now anyway. 🙂
It s fine line with so many variables. In your example… “Take a variable outstanding $100,000 loan with an interest rate of 5% that was costing $5,000 a year in interest payment. With the increased bank rate of 0.25% the loan is costing 5.25% or an extra $250 per year more than before. I want to know how I can lower my cost of borrowing back down to $5,000/year.” Options: a) For the extra $250/yr in interest what would you need to do to increase your income to cover the increase interest payments? b) On the decision to start paying more to the loan versus paying yourself is really a personal decision since when you started leverage it provided you with positive cash flow. Have you considered that there maybe further BOC rate increases in the near future & how this would impact any investing strategy when it comes to margin/leverage? c) why not just increase income to cover the added cost of borrowing that you have done in the past. d) sell of any assets that would cover extra interest rate increases. This would result in a lower income because your leveraged/margin is currently giving you a higher return… Read more »