How to Prepare for Higher Borrowing Costs
My debt to income ratio is about 500% while the national average is around 173%. Readers sometimes email me and ask what I will do when interest rates rise. My answer is simple.
I tell them I will pay down my debts in an accelerated manner prioritizing the highest interest loan first. I will limit my monthly interest expense to no more than $1,500. Doing this will adequately protect myself from interest rate risk. Sounds like a solid plan, right? 😉
But I know not everyone will agree. Back in 2014 I noticed some people were concerned that I had taken on excessive risk because my debt level was too high. This sentiment echoed around various internet forums. Here are some examples I’ve saved.
The last commentator wanted to know how I’m doing now. That’s what I’ll be discussing in today’s post. 🙂
But first, here’s a look at my debt summary in 2014. The numbers are taken from my net worth update 4 yrs ago.
|Liquid’s 2014 Debts||Balance||Interest Rate||Annual Interest Cost|
|TD Line of Credit||$33,700||5.25%||$1,769|
|CIBC Line of Credit||$14,000||4.50%||$630|
|Total Debt Balance||$531,800|
|Average Weighted Interest Rate||3.47%|
|Total Cost of Debts||$18,474|
Back then I had nearly $532K of debt, charging me an average interest rate of 3.47% per year.
I was paying $1,540 per month in interest. But I was cash flow positive and saving about $1,000 per month. I felt like I had everything under control. So I didn’t understand why people claimed I was overly leveraged. I thought maybe I was missing something. But as Bobby McFerrin would say, “don’t worry, be happy.” 😀 So that’s what I did.
And here’s what my debt looks like today, 4 years later. 🙂
|Liquid’s 2018 Debts||Balance||Interest Rate||Annual Interest Cost|
|TD Line of Credit||$5,000||5.45%||$273|
|CIBC Line of Credit||$17,500||5.00%||$875|
|Total Debt Balance||$459,000|
|Average Weighted Interest Rate||3.49%|
|Total Cost of Debts||$16,083|
So my debt costs me $16,083/yr or $1,340 per month right now. This is actually $200 per month lower than in 2014, despite interest rates being higher today.
Yay. Bobby was right. There was no need to be worried. 😀
Nearly every asset class I hold long positions in has produced decent returns since 2014. Had I not borrowed and used other people’s money to invest I would have missed out on all the investment gains.
Debunking the Myth of Rate Hike Doom
A common myth is that if interest rates move higher, people who use leverage like myself will be screwed. But the reality is that consumers adapt. So by the time interest rates in Canada move significantly higher, debtors will be in a better position to absorb the extra cost. 🙂 Here are some reasons why.
- A debt balance shrinks after each payment. For example, my debt amount has decreased by 14% since 2014.
- We tend to make more money over time. My personal income has risen 50% since 2014. This makes it easier to pay down my loans as I can save more money.
- Interest rates can drop quickly but tend to climb slowly. Since 2014 the BoC has raised rates by only 0.50%.
We have to consider these 3 factors in context with changing interest rates.
My stress test shows that the Prime lending rate would have to increase by 4.00% before I would run into trouble servicing my debts. But a drastic rate change like that is practically impossible in the near future. According to CTV, 42% of Canadians say they are $200 or less away from financial insolvency, with little cushion to pay unexpected bills. And 40% say that if interest rates rise any further they fear they will be in financial trouble.
This is why I’m not worried about monetary tightening. When I’m being chased by higher interest rates, I don’t need to be fiscally fit to outrun it. My plan is to just run faster than others who are less financially solvent. 😛
But having said that, I have not yet tested my investment strategy in a bear market.
“Only when the tide goes out do you discover who’s been swimming naked.”~ Warren Buffett
I don’t know how my net worth will hold up during the next recession. But I think Trump and the Central Banks will try to prolong this current market rally for as long as possible, lol. 😀
Random Useless Fact: