Life With Low Rates

An opinion piece by Jerry

With the Federal Reserve in the U.S. announcing that rates will be kept low until into 2013, Canada's own government bond rates have dropped and will most likely stay relatively low for the next year and half as well.

What does this mean?  With an almost guarantee of low rates for the next few years this will mean something very different to 2 groups - the savers/investors and the borrowers.

Savers & Investors - Low rates mean low returns on the safest investments.  This means bonds, GICs and term deposits.  With so many baby boomers looking at retirement over the next dozen years (or much sooner) they want a good return to build up their retirement fund.  The reality is that returns will be low, unless they go into riskier investments like mutual funds and stock markets.  However, principal and returns are not guaranteed with mutual funds and stocks, so investors need to be careful how much of their portfolio they put into the riskier investments while hoping for higher returns.

Rates Are Going To Rise

Rates have been at historic lows for about 2 years in Canada, and about 3 years in the United States.  As the international and national economies improve, interest rates really have nowhere to go but up, and that is going to impact you.

There are 2 groups of consumers who will be most concerned with increasing rates: Investors/Savers and borrowers.  The first wants rates to increase, the latter does not.

What Happens With Low Rates

The Bank of Canada Governor, Mark Carney, has been warning Canadians for a while now that we will be in a low interest rate environment for a few years.  He has clarified that by "low" he means lower than average, not necessarily as low as interest rates have been over the past 2 years.

This past week a deputy governor at the Bank of Canada also spoke about low rates and their impact, warning that while usually good for the economy, people's behaviour can create risk during low rate times.

The following is a short list of impacts that low rates have on the economy:
Low Inflation - The Bank of Canada is trying to keep inflation between 1% & 3% annually.  They can influence this by increasing or decreasing the Bank of Canada overnight rate, which is the rate the BoC charges Banks for borrowing money from them to cover some daily incidentals.  Because inflation has been very low for the past 2 years, the BoC rate has been very low.  This means it costs the banks less to borrow money, and the lower cost is passed on to consumers and businesses through lower loan costs.

Confusing Posted Rates

There are a lot of rules around how banks post the rates on their websites and in their branches.  The spirit of those rules is to make it easy for consumers to understand what the real cost or gain is to them.  I have to say that most banks do a pretty good job of trying to make their rates clear and understandable, but there is one product out there that continues to confuse people with its almost misleading rate advertisements – that is the escalator term deposit.

For most 5 year term deposits (redeemable or non-redeemable) the posted rate is the compounding rate you get on your money every year.  So a 5 year term deposit at 3.01% compounding annually means just that – you get 3.01% compounding every year.

For a 5 year escalator, the rates are laid out in the following way:
Year 1        0.4%
Year 2        1.1%
Year 3        1.3%
Year 4        2.1%
Year 5        6.4%