Budget Sense

The feds have cranked up the heat and people are responding by looking for something to cool them off! I use this analogy to explain what has happened in the last 18 months of the Bank of Canada’s unprecedented interest rate hikes, taking it from 0.5% in March 2022 to the current rate of 5%. That is effectively close to 900% of rate hikes in a span of just 18 months! No wonder people are not only feeling the pinch, it is more of a squeeze or even a crush, depending on people’s financial well-being.

Numerous mortgage holders have experienced the repercussions of elevated borrowing expenses, driven by the Bank of Canada’s decision to raise interest rates ten times since March 2022, ultimately reaching a policy rate of five percent.

As a result, some people are being forced to sell their homes, as the interest rate have become too much to afford. Others are not selling but are being forced to take on second jobs or find other incomes to make up the difference. As I said in my opening remarks, the feds cranked up the heat – to combat that other issue of inflation – and people are not only feeling the heat, there is not much they can do and can just hope for the temperature to go down soon on its own. In fact, things have been so bad lately that some individuals have resorted to extending their amortization periods by several decades, opting to pay only the interest on their homes.

How to cope?

Seems like a lot of gloom and doom and it is not stretch, as most of us are feeling it. But there are always things that can help. You can start off by looking at your budget and see where you can make some cuts, especially if your income has remained the same last 12 months, while your mortgage payment goes up. For example, if you are planning to go on a family vacation in the next 6 months and this vacation will cost the equivalent of 2 or more monthly mortgage payments, it would be highly recommended and the responsible thing to skip it and save that money instead. Even if you don’t put it on something else, set the money aside for now, until these tough times are somewhat behind us.

Also, if your mortgage is up for renewal in the next 6 months, and given the anticipation of unavoidable higher rates, it’s advisable to initiate discussions with your mortgage broker about your options. This includes considering more extreme measures such as switching to interest-only payments or extending your amortization period. These alternatives are far preferable to the last resort of selling your home. If your payments are set to increase, even if the increment is modest, you might also explore the possibility of taking on a part-time job to cover the added costs. Alternatively, if feasible, consider seeking extra hours at your current job.

With interest rate being high, we can also benefit if we have some money set aside, by putting it in a high interest saving account. For example, some banks are paying as high as 5% for regular saving account, and 5.5% or more for 1 year GIC. These are rates some of us have never seen in their lifetime, so why not take advantage of them? It is simple math: imagine having $25K family savings set aside that you have no use for anytime soon. Why not put it in a 1 year GIC: assuming 5.5% interest rate, you will be getting a cool $1,375 one year from now, with virtually no effort on your part other than the few seconds needed to create the account and transfer the money.

In this challenging financial landscape, it’s clear that Canadians are feeling the heat of unprecedented interest rate hikes. of the last 18 months. From adjusting budgets to exploring alternative mortgage solutions, there are ways to weather this storm. By making informed decisions, seeking professional advice, and taking advantage of high-interest savings options, individuals and families can navigate these turbulent times with resilience and hope for a brighter financial future. In other words, patience and discipline are needed, until this storm passes. As we ride out the wave of rising rates, remember that financial stability is achievable through careful planning and smart choices, ensuring that your dreams and aspirations remain well within reach.

Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it” . If something has the backing of arguably one of the smartest people in history, you can surely trust it!

Compounding is the process whereby interest is addedto an existing principal amount as well as to interest already paid. We have heard of something called ‘tax on top of tax’ which governments may annoyingly do at times. Compounding is similar to that but in our favour: it is effectively interest on interest.

Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns. For example, Let’s assume you have $5000 in a savings account that earns 5% in annual interest. In year one, you’d earn $250, giving you a new balance of $5250: by next year, you will earn interest on this new amount of $5250 and so on. Before you know it, your money has magically gotten much bigger than what you started with, especially if you give it enough time to grow exponentially.

You may have read the example of a penny that doubles every day to become worth over $5,000,000 by day 30. While that is an extreme example, the lessons here are applicable: that compounding + time , ends up doing wonders to your money.

Compounding can also be thought of in terms of dividend reinvestment plans (DRIP) where money earned from dividend income is reinvested to buy more shares which in turn end up buying more shares and so on.

At the timing of writing this article, savings interest rate are at an almost decades high, with some banks paying 5% or more for certain savings or GIC accounts. So putting $10K in a savings account with such a rate will give you $500 in one year and you can then reinvest that amount and in one year from then (assuming the same 5% rate) you would get $525 on that $10500 for a new total of $11,025. So using compounding, you turned $10K into $11K and change in just two years! Now imagine if you had more money and have more years to leave it there. For example, if you leave your money in the bank for 5 years, and earning the same 5% interest rate, you would get close to $3K extra or $12,762.82 to be exact.

Compounding is a great tool to use on your road to wealth and financial freedom. It is effortless and it helps that we are now at decades long historical highs for interest rate paid by the banks. So put it all to use and reap the benefits in just a few years.