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Wednesday, April 28, 2010

Five reasons to love rising interest rates

April 28, 2010

By John Heinzl
From Wednesday's Globe and Mail

The end of cheap money is good news for savers, seniors and fixed-income investors
With the Bank of Canada poised to raise interest rates as early as June, nervous borrowers are bracing for the end of cheap money.

Big disaster, right? Hardly.

Sure, consumers carrying onerous amounts of debt will feel the pain when rates climb from today's ultralow levels. But for others - savers, seniors and fixed-income investors, for example - higher rates can't come soon enough.

Rising rates might even restore some sanity to segments of our economy that have gotten drunk on all the easy credit. So, with banks already ratcheting up mortgage rates and bond yields creeping higher, let's take a deep breath and focus on the positives.

Here are five reasons to love rising interest rates.

No more bidding wars

The chit-chat on every street corner is the same: "You know that two-bedroom eyesore with the sagging front porch and the raccoons living in the attic? It went for 100 grand over asking."

This sort of lunacy will not last. Here's why.

When the bank decides how much it will lend you to buy a home, it uses an affordability formula based on your income, expenses and the interest rate on the loan. The lower the rate, the smaller the monthly payment, and the larger the mortgage it will give you. Many home buyers gladly take the maximum the bank offers, pushing home prices skyward. (The chart shows just how stretched home prices have become compared with incomes.)

But plug higher interest rates into that same affordability formula and guess what happens? Home buyers suddenly qualify for smaller mortgages. Even a couple of percentage points can mean a difference of $100,000 or more in the maximum loan size.

With less borrowed money sloshing around, home prices will inevitably fall. When that happens, housing market psychology could rapidly turn bearish. For first-time home buyers or real estate investors who are sitting on cash, this would be the time to get in.

Investor Education:
Should I buy a home now, or wait and save more money? [http://www.theglobeandmail.com/globe-investor/investment-ideas/investor-education/chapter-5-should-i-buy-a-home-now-or-wait-and-save-more-money/article658096]
Understanding house prices [http://www.theglobeandmail.com/globe-investor/investment-ideas/investor-education/understanding-house-prices/article658078]
Is it better to buy a home, or choose some other investment? Charlie's story [http://www.theglobeandmail.com/globe-investor/investment-ideas/investor-education/is-it-better-to-buy-a-home-or-choose-some-other-investment-charlies-story/article658068]
What makes buying a home different from other investments? [http://www.theglobeandmail.com/globe-investor/investment-ideas/investor-education/what-makes-buying-a-home-different-from-other-investments/article658074]
What are some renovations that add value to my home? [http://www.theglobeandmail.com/globe-investor/investment-ideas/investor-education/what-are-some-renovations-that-add-value-to-my-home/article658065]

Higher GIC rates

A couple of months ago, the best rate I could find on a five-year guaranteed investment certificate was 3.25 per cent. But when I checked my discount broker yesterday, one financial institution was offering 3.9 per cent, and several others were at 3.8 per cent.

The way things are going, I wouldn't be surprised to see five-year GIC rates crack 4 per cent in the weeks ahead as financial institutions compete for deposits. The dividend yield on the S&P/TSX composite index, by comparison, is a lowly 2.6 per cent.

Suddenly, GICs are interesting again, particularly for seniors and other investors who can't stomach the risk of the stock market. Short-term bond prices have also fallen, pushing up yields and making these fixed-income securities more attractive for investors.

Stock market bargains

Rising interest rates hurt the stock market in several ways. They make bond yields more attractive, raise costs for sectors such as utilities that carry a lot of debt, and compress price-to-earnings multiples.

Many analysts say the stock market is overdue for a correction after its 61-per-cent gain from the lows of March, 2009, and rising interest rates may be just the thing to tip it over the edge. Another reason to expect a correction is that the market is heading into the seasonally weak May-to-October period (hence the phrase "sell in May and go away").

Nobody likes to see their stocks fall, of course, but a correction would be a welcome development for investors who have cash to spend or who reinvest their dividends in more shares, because their money will go further.

Cheaper road trips

If you've been itching to visit Graceland or the Grand Canyon, now's your chance.

Even as Canada's central bank prepares to raise rates, the U.S. Federal Reserve Board is widely expected to stay on hold at least until the end of the year because of the weaker U.S. economy. That divergence has lit a fire under the Canadian dollar, which is hovering near parity with the greenback.

True, a strong dollar is bad news for our exporters, but if you're planning to visit the United States, it's like the entire country has been put on sale.

Happy savers

To the extent that rising interest rates cause prices of homes, stocks and other assets to fall, folks with the foresight to save will be the big winners. That's because they'll be in a position to scoop up assets at discounted prices. Which leads to another upside of rising rates: If you're planning to park your cash in a "high-interest" savings account, these vehicles might actually start living up to their name.

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