Jan 152018
 

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
Mortgage$200,0002.95%$5,900
Farmloans$208,3003.40%$7,082
Margin Loans$52,9004.25%$2,248
HELOC$17,9003.60%$644
TD Line of Credit$33,7005.25%$1,769
CIBC Line of Credit$14,0004.50%$630
RRSP Loan$5,0004.00%$200
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 DebtsBalance Interest Rate Annual Interest Cost
Mortgage$180,3002.80%$5,048
Farmloans$185,3004.30%$7,968
Margin Loans$57,0002.40%$1,368
HELOC$14,9003.70%$551
TD Line of Credit$5,0005.45%$273
CIBC Line of Credit$17,5005.00%$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.

  1. A debt balance shrinks after each payment. For example, my debt amount has decreased by 14% since 2014.
  2. 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.
  3. 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. 😀

 

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Random Useless Fact:

 

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Dividends Diversify
Guest

F35, That is rough crowd of commentators from years back. I am very debt averse, but hey, to each is own. If you comfortable with it, then who am I to say. Being a lender, I look forward to higher rates. Hopefully they increase in an orderly process and are due to economic growth. Tom

RICARDO
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RICARDO

If we were to listen to all the naysayers the economy would be in the proverbial (insert Trump country euphemism). No one would do anything. I have previously run my HELOC up to $160K for a taxable investment account. Paid it off and sit with $75K in the bank for my retirement. That is not to say to throw caution to the wind. There will be losers and winners. Some who will swear off debt and others who will judicially use it to their advantage. I hope to be one of the latter. Seeing I am now retired my perspective on debt has changed somewhat in so far as my timeline has shortened. I may still run up the HELOC ladder if I perceive the time is right. Hopefully I will not have to swear off debt.

RICARDO

Howard Roark
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Howard Roark

Hi F35, long time reader and fan. My Assets/Debt/Net Worth is very similar to your most current numbers, also Canadian like you, which is why it’s interesting to read your monthly updates. The major difference is our portfolio compositon (I own all dividend/distribution yielding stocks and my only debt is margin debt) and income level. One additional bonus to add is that the interest debt from the stock part of your portfolio in the margin account (I use IB as well, in fact it was your article on switching to IB that finally motivated me to switch to there as well) can be deducted from your income for tax reasons! This results a bigger tax return which I put 100% back into my margin account, further lowering the debt. I’m fairly high income (in the six figures), so having this write-off is nice. In fact, because the IB interest rates are so low, in order to get more write-offs and in the future and execute my RRSP meltdown strategy, I’m going to need higher interest rates! But as you said, while you and I could handle a steep rise, historically this is not how central banks work, and the rest… Read more »

jambr403
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jambr403

Great post.
There is a difference between going into debt to buy a new 328i Bimmer and 320 acres of productive farmland in SK!

Financial Orchid
Guest

Long time reader here. What are your plans in 4 years? Are you going to relax spending a little while keeping your job or cut back on all the side hustles?

Derpy McDerp
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Derpy McDerp

“Interest rates can drop quickly but tend to climb slowly.” Until they don’t. Black swan event, violent downturn in economic output, excessive money printing, hyperinflation, interest rate spike. A very real possibility.

P C
Guest

Don’t you just love haters and laugh in their faces when you give them the updates!

Dividend Earner
Guest

Compare to those that might be in trouble, you know exactly where you are at and are not using leverage to buy the next iPhone but to build income generating assets. There is a big difference here.

Congrats on being able to go back and show what 2014 was like and to have a clear understanding of your loans.

dividendgeek
Guest

Nice article. Back in 2013 I got too worried about rate hike. Sometime around June there was a huge drop in bond prices. Right before that I switched all my assets to bonds. S&P 500 was at an all time high and I was not sure if it would stay that way. Well, I lost one of the best returns for that year. Never doing that again. I believe interest rates will go up slow and steady. As long as it is possible to service debts it should be okay to borrow. One thing I would like to mention is that we are in an awesome bull market. Borrowing and investing will definitely work out. It remains to be soon how market will progress.

AlW
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AlW

I think as long as your returns outpace the rise in interest costs you’re going to be ok. Personally, I’ve got about 1.7M in assets and 800K in liabilities – all at or below prime with the exception of a 7K HELOC at prime +0.5%.

My major concerns with it all are cash flow and taxes. Most of the debt is in real estate and covers the carrying costs easily. We’ve been using the excess to fund my wife’s maternity leave I hope she returns to work soon.

GYM
Guest

Ouch those are some tough comments- I would feel a bit miffed reading that in forums! Hope they are enjoying their “Haterade” right now.

Keep up the good work, I might look into using my HELOC too shortly.

Actually I was talked about on my previous blog on forums too by Garth Turner and I think I remember reading the comments and crying. Haha. It was about my housing purchase back in 2012. They said I was going to go belly up because the housing market was going to crash. Well, we all know what happened with the Vancouver real estate market since 2012!