The coronavirus pandemic has hurt the economy bad, sending interest rates down. What does that mean to you, your mortgage or your investments?
Canada’s central bank lowered its key interest rate three times in the past month to a current level of just 0.25%. While that’s not the rate of interest you will earn on your savings or pay on your debts, it does impact those consumer rates and the economy as a whole.
Here are some of the ways you can expect falling interest rates to affect you, from mortgages to savings to investments.
Why the drop in rate?
The Bank of Canada’s benchmark rate—called the overnight rate—is the rate of interest financial institutions use to borrow money from each other for one day. In turn, this key rate influences the rates individual banks charge when they loan you money or pay out interest on your savings.
The Bank of Canada uses its overnight rate to regulate the economy. For example, when the economy slows down (as it is currently due to the coronavirus pandemic), they lower interest rates to encourage financial institutions to decrease interest rates on their loans and mortgages. This makes borrowing money cheaper for consumers and businesses who will go on to spend and invest those borrowed dollars, helping to boost economic activity.
What does that do to my savings?
Financial institutions take their cues from Canada’s central bank, and many have lowered the interest rates offered on savings accounts. That means any money you’ve socked away in a bank account will earn less in interest income than before the rate drops.
If your savings are in Term Deposits, or GICs (guaranteed income certificates), you will continue to receive the rate of interest agreed to at the time you purchased them until their maturity date.
How will the rate drops affect my mortgage?
As with savings accounts, a number of financial institutions have lowered the prime rates on their mortgages in the wake of the Bank of Canada rate cuts.
If you have a variable rate mortgage, you will immediately see a reduction in your rate. That means the interest paid will go down, and likely your payments would decrease. But, if you choose to keep your payment amount the same as it was before the rate drop, the savings you enjoy from the lower interest rate will be put toward paying down more of the principal each month.
If you have a fixed-rate mortgage, your monthly payments (or amortization) will not change. If you’re buying your first home or refinancing an existing mortgage, the low interest rates could work in your favour.
What Does it Mean For My Investments?
During low-rate environments, businesses and consumers usually look to investments to obtain higher returns on their savings than bank interest provides.
But financial markets hate uncertainty, and you can’t get more uncertain than an unprecedented global pandemic that’s threatening both health and incomes. The markets have been understandably volatile in the past month with the value of Canadian stocks falling by about 30%, according to the S&P/TSX Composite Index.
While that may sound alarming, and most of our own RRSP portfolios are probably down considerably—but since I’m not set to retire in the next decade and the markets eventually rally, I’d rather not obsess over how much money I’ve lost on paper. Don’t panic and start selling off assets or you may sit out the recovery and realize real losses. In the meantime, if my income remains stable, I’m continuing to make my usual monthly investment contributions.
A certain amount of volatility is baked into the market, and the best course of action is to stay invested for the long-term rather than lock-in investment losses by selling.
How to do I maximize investment returns?
No matter what interest rates or the markets are doing, there are solid ways to maximize your returns:
Diversify your portfolio
This means choosing investments across a variety of sectors, different global markets (Canadian, US, international) and with a balance of asset types (equities, bonds, etc.). That way, if one sector, location or asset type performs poorly, other investments in your portfolio will hopefully offset those losses.
Tax shelter your investment earnings by putting them in an RRSP or TFSA
Any investment income (including from term deposits, stocks, bonds, mutual funds, or index funds) is taxable income, unless the investments are held within a registered account. But which should you choose: TFSA or RRSP? The main differences between registered accounts are how and when you are taxed on contributions and earnings.
With an RRSP, you get the benefit of a tax deduction for your contributions in the year you make them and your investments grow tax-free while inside the RRSP. But you must pay income tax in the year you start to withdraw funds. Your annual RRSP contribution limit is 18% of the previous year’s earned income, up to a maximum of $27,230 for 2020.
With a TFSA, there is no tax deduction when you contribute and your investments grow tax-free while inside the TFSA. The real benefit comes when you withdraw the money — completely tax-free. The current annual TFSA contribution limit is $6,000 (2020) and the cumulative maximum is $69,500 for those who were 18 or older in 2009 when TFSAs were first introduced.