I don’t often have much to say about macroeconomic issues, but an article “sounding the alarm” about how interest rate increases are affecting car companies drew a reaction. “Aggressively raising interest rates has helped create an untenable situation in car financing.” Good.  Financing a car is usually a mistake for the consumer.  When consumers’ credit is so bad that they can’t even get a car loan, it’s even clearer that they shouldn’t buy the car. “The auto sector is one of the victims of the aggressive interest rate hikes.” Ridiculously low interest rates have allowed car companies to inflate prices and sell ever more cars to people who can’t really afford them.  The fact that the party is ending doesn’t make car companies victims.  Conditions are just slowly getting back to normal. “Rising interest rates will make consumers reevaluate their decisions before quickly jumping into a car loan.” Good.  It’s sad when people bury their financial future by buying ...

There are many ways to hide banking fees so that customers don’t notice them.  One way is to quietly help yourself to a couple percent of people’s mutual fund savings every year.  Another is to tack a foreign exchange fee onto the exchange rate when customers exchange currencies.  I learned about a new one recently with credit card payment plans. Many of the big banks offer plans that allow you to take a credit card purchase and pay it off over 6 months to 2 years at a low-sounding interest rate.  The trick is that they add fees that also seem small, but they add up. One example is TD’s credit card payment plan that allows you to pay for large purchases over 6 months at zero percent interest for a one-time fee of 4%.  This sounds way better than paying standard credit card interest rates.  However, looks can be deceiving. Suppose you make a $600 purchase.  With the 4% fee, this grows to $624.  At 0% interest, you could use the payment plan to pay ...

Rising interest rates are causing a lot of unhappiness among bond investors, heavily-indebted homeowners, real estate agents, and others who make their livings from home sales.  The exact nature of what is happening now was unpredictable, but the fact that interest rates would eventually rise was inevitable. Long-Term Bonds On the bond investing side, I was disappointed that so few prominent financial advisors saw the danger in long-term bonds back in 2020.  If all you do is follow historical bond returns, then the recent crash in long-term bonds looks like a black swan, a nasty surprise.  However, when 30-year Canadian government bond yields got down to 1.2%, it was obvious that they were a terrible investment if held to maturity. This made it inevitable that whoever was holding these hot potatoes when interest rates rose would get burned.  Owning long-term bonds at that time was crazy . One might ask whether we could say the same thing about holding stocks in 2020 ...

Recent reports that TD will start charging compound interest on all personal credit cards are only partially true.  TD was charging some compound interest on these credit cards and will start charging more. The relevant section of the credit card agreement used to read as follows: If interest is charged, it is calculated on the average daily balance of each Transaction from the transaction date until that amount is paid in full.  The total is the amount of interest we will charge you on each statement on the last day of your statement period. The new agreement replaces the last sentence with the following: We add your unpaid interest charge to your balance at the end of each statement period.  As a result, we charge interest on unpaid interest. The difference is in the time from the end of a statement period until the due date for your payment.  During this time on certain personal credit cards, TD is now charging daily interest on the newly accumulated i...

Does a 0% interest loan sound too good to be true? You can get a 12-24 month installment loan from Brim Financial, and they claim to charge 0% interest. Not many borrowers will truly believe the cost is zero, but few will guess how expensive these loans really are. Brim replaces “interest” with “fees”. There is a one-time installment fee of 7% of the loan amount that you have to pay in the first month. Then there is a 0.475% monthly processing fee. This fee is based on the original loan amount, not the declining balance owed. Suppose you borrow $1200 for 12 months. The monthly payments before fees are $100. In the first moth, you pay the 7% installment fee ($84 in this example). You also pay a monthly processing fee of $5.70. In total, you pay $189.70 in the first month, and $105.70 for the remaining 11 months. The internal rate of return works out to 2.00% per month, and this compounds to $26.9% per year. So, these carefully crafted loan terms combine 0% interest with ...

A fellow financial blogger asked my opinion about his upcoming mortgage renewal. He faces the same choice as many of us do: should you take a fixed-rate mortgage or go for the lower variable rate? The risk with the variable rate mortgage is that rates might rise. The answer requires surprisingly little math. If rates stay the same for 5 years, then the lower variable rate will save you money compared to a 5-year fixed-rate mortgage. If rates go down, you’re even further ahead. Averaged over all possibilities, the average outcome is that you save some interest on a variable-rate mortgage. The worry, though, is the possibility that rates go up. You can’t fully protect yourself against rising rates even with a 5-year fixed rate, because you’ll have to renew at a new interest rate after 5 years. But you might hope to get your balance down enough that you could absorb an interest rate increase in 5 years. The real test of what you should do comes with looking at a terrible outc...

The only virtue of simple interest is that it is easier to calculate the amount owing than when we use compound interest. However, in today’s world, computers do our calculations for us and this advantage means very little. Despite its name, I’ll show that simple interest is far more complex than compound interest in important ways. A Basic Example Let’s start with an easy example to illustrate the difference between simple and compound interest. You borrow $10,000 from Uncle Jack to be paid back in 10 years. Uncle Jack isn’t a very loving uncle and knowing you have no other options he charges you 10% interest each year. If Uncle Jack charges simple interest, then your debt rises by $1000 each year for a total of $20,000 after 10 years. The 10% interest is always charged “simply” on the original principal amount. To put this into a formula, if the interest rate is r =0.10 per year, the number of years is t =10, the initial loan amount is M =$10,000, and the future value aft...

Recently, Rob Carrick interviewed Rick Lunny from the Melrose Management Group to discuss mortgage defaults. Lunny explained that the main reason people default on their mortgage is not rising interest rates, but people losing their jobs. Lunny said that he had “been involved in studies that go back 30 years, and you see that unemployment is the number one reason for mortgage default.” Let’s take a look at the history of Canadian interest rates for the past 30 years: The trend of dropping interest rates should smack you in the face. How could Lunny’s study say much about whether rising interest rates lead to mortgage defaults? Apart from 1988 to 1990, Canadians haven’t had to face much in the way of rising interest rates in the past 30 years. Keep in mind that it’s not high interest rates that cause your payments to rise. After all, the bank takes into account current interest rates when they decide how much to lend to you. What causes your payments to go up is the inc...

A colleague recently asked me if I knew of a good source for reliable interest rate predictions. He was trying to decide whether to break his mortgage and pay the interest rate differential. He only wanted to do this if interest rates were headed back up and it made sense to lock in today’s low rates. As is often the case, I knew the correct but unhelpful answer. Nobody knows for certain what will happen to interest rates. Even the U.S. Federal Reserve and the Bank of Canada can’t say what will happen to interest rates with any useful accuracy. These organizations react to world events more than they control them. The yield curve gives the collective interest rate predictions of the financial markets , but rates could be higher or lower than predicted levels. We need to stop looking for financial prophets and make financial choices assuming a range of possible outcomes. The curious thing about this line of reasoning is that I’ve had people agree with it and then proceed to ...

Commentators frequently recommend that people negotiate the interest rate on their mortgages, lines of credit, GICs, and other loans and investments. But not much is usually said about how to go about such negotiations. I don’t have all the answers, but I did recently negotiate for a better interest rate on a line of credit. The process surprised me in a few ways. I have an unsecured line of credit that has been mostly dormant for 17 years. A recent temporary need for money led me to use it and find out that the interest rate I’m being charged is prime+4.5%. After a quick poll of friends, it seemed that I could certainly do better. I decided to do what I could to reduce this interest rate as quickly and easily as I could. I figured the easiest way to proceed would be to simply call the bank’s general phone number and provide an update on the 17-year old information they have about me. Surely it would be obvious that my financial circumstances warrant a lower interest rate. ...

I have a 17-year old line of credit that has seen very little use. I have it “just in case”. A recent temporary need for money led me to use it instead of selling investments, but I never actually checked on the interest rate. The rate turns out to be prime+4.5%. Ouch. I’m not exactly up on appropriate interest rates for unsecured lines of credit since the credit crisis, but this seems a little high. Perhaps the problem is that the bank is determining the interest rate partially on 17-year old information I gave them when I opened the line of credit. Or maybe they are just hoping that I won’t notice. Either way, I’ll be off to the bank to try to get a better rate soon. Anyone else who has an old line of credit but hasn’t looked at the interest rate lately might do well to check it and possibly try to get it lowered.

Canadian Tire Bank is offering a 1% bonus on the interest rates they pay on high-interest savings accounts (HISAs). For the first 90 days for new customers, the regular HISA currently pays 2.5% and the TFSA HISA pays 3.5%. But, how much is this bonus interest really worth? If you put $5000 into one of these accounts, the extra 1% interest over 90 days will earn you a bonus of a little over $12. After the 90 days are up, the interest rate will return to normal, which is currently 1.5% for HISAs and 2.5% for TFSA HISAs. Getting an extra $12 is better than a kick in the head, but the important thing is to compare the regular interest rates offered on savings accounts by different banks. Unfortunately, the banks tend to trumpet introductory rates and downplay regular rates. If you're thinking about taking Canadian Tire Bank up on their offer, a couple of points in the fine print to consider are that the bonus 1% has a balance cap of $100,000 and that interest rates are subjec...

Most of us have heard of the rule of 72. If you are paid an interest rate of say 6%, then it takes about 12 years to double your money. The “rule of 72” part comes from 6 times 12 equals 72. Similarly, it would take only about 8 years at 9% interest. However, this so-called rule is just an approximation. When you multiply an interest rate in % by the number of years it takes to double your money, you get the following chart: The rule of 72 turns out to be exactly accurate at about 7.85%. But up at around 26%, it should be called the rule of 78. Down around 1% or 2%, it should be called the rule of 70. Blindly applying the rule of 72 for interest rates of 1% and 2% gives answers that are slightly off. The real times to double your money are about 70 and 35 years rather than 72 and 36 years. This kind of error certainly isn’t a big deal when doing back-of-the-envelope calculations, but I prefer to know when rules are accurate and when they are just approximations.

There is no shortage of speculation on what will happen with interest rates. Some commentators predict sharp increases and others predict stable rates. Maybe there are some who predict that interest rates will drop a little. Many borrowers listen to these predictions trying to decide whether they have to do anything about their growing debts. This way of thinking is dangerous. Just because a convincing forecaster says that interest rates will not rise, we should not ignore dangerous debt levels. Debtors should look at the range of possibilities rather than listen to experts make precise predictions. The truth is that nobody knows for sure what will happen with interest rates. The best rate I was able to find for a 1-year closed mortgage is 2.64%. In three years, this rate could easily be anywhere in the range 2% to 8% or higher. Borrowers should ask themselves what will happen to them if rates rise steadily to 8% in the next 3 years. Will finances be a little tight or will...

PBS aired a very interesting story called The Card Game that takes a look at bank practices that exploit people when they start to have money problems. The story explained some of the more unpleasant practices and debated whether they should be stopped. Another concern was how they could be stopped without undermining free enterprise. One of the slimier practices described was overdraft fees on debit cards. In the example given, a consumer doesn’t realize that his bank account balance is low and goes about his business for a month making debit purchases. The bank then takes all the debit transactions, reorders them from biggest to smallest so that the account is drained on the first few transactions, and then charges a $35 fee on each overdraft transaction. So, a $5 coffee becomes a $40 coffee. This is a very nasty practice clearly designed to severely punish the unwary. There is no reason to believe that the bank’s exposure to a potentially bad loan is any different if the c...

There is no shortage of commentators making predictions about interest rates. This is because they can get the attention of just about anyone who has investments. Those who depend on interest income want higher rates, and those who have stocks and bonds generally prefer dropping interest rates. It is possible to predict interest rates with better success than flipping a coin, but not in any useful sense. The market’s prediction on interest rates can be found by examining the current yield curve, which is a chart showing short-term and long-term borrowing interest rates. Typically, yield curves focus on government borrowing costs in the form of bond interest rates. The Bank of Canada maintains data on yield curves going back to 1986. Here is the most recent yield curve data for the last day of August: Typically, short term rates are lower than long-term rates because investors demand a higher return when their money is tied up longer. So, the yield curve tends to slope up...

The Bank of Canada dropped its interest rate by half a point to 1%, and the banks dropped their prime rates by the same amount to 3%. The banks have been criticized for not passing on lower interest rates to consumers, but they have this time. In some cases, mortgage rates have dropped by more than half a point. It’s interesting that in the aftermath of a financial crash brought on by too easy credit, particularly in the U.S., the fix is to make credit easier to get. I’m not saying that I disagree with this policy; it just seems a little ironic. Eventually we will pull out of recession, and it will be interesting to see how close we get back to the way things were. In theory, banks should have learnt some lessons and should maintain higher standards for lending money than they had before the crash. But, they face considerable pressure to loosen their purse strings right now. I’d like to think that lending policies in the future will be sane, but we may see lending standards ...

1. Rogue Clients Falling stock prices mean that financial advisors need to beware of lawsuits from “rogue clients” according to Gowlings’ Ellen Bessner in her interview with the Wealthy Boomer (the web page with this article has disappeared since the time of writing). She defines a rogue client as an investor who claims to have a high capacity for risk but says something different when markets decline. I prefer “insurgent clients” or “terrorist clients” to really drive home the imagery. Perhaps the real reason these clients are angry is because various marketing efforts gave them unrealistic expectations about the advisor’s ability to beat the market and protect their portfolios from loss. Just a thought. 2. Bank Prime Rate The Big Cajun Man added his voice to the many others observing that reductions in the central bank rate are not being fully passed on to borrowers. On one level this makes sense because the banks are recovering from a period where they lent money to borro...

We’ve watched as credit markets have seized up and world governments have pumped trillions of dollars into the banking system. Many of us want to know whether these efforts are working, and when we’ll get back to normal. According to Business Week, bank-to-bank lending rates in the US have dropped eight straight days (the web page with this article has disappeared since the time of writing). This doesn’t mean that the problem is solved, but we are headed in the right direction. This is as close as I can get to answering the question of whether government intervention is working. As for the question of when we’ll get back to normal, I don’t think we will get back to normal. For many years, “normal” was to lend money to people who couldn’t pay it back. It was normal for investors to buy packaged loans for much more than they were worth. Until we have another bubble that leads once again to lending madness, we won’t go back to the way things were before. There is nothing susta...

In a previous article we discussed how increasing a portfolio’s risk level can increase expected returns . This risk premium is most dramatic for long-term returns. You might ask can we keep increasing the risk level indefinitely to get ever higher expected returns? The short answer is no. Starting from a low-risk portfolio of fixed-income investments, we can increase risk and return by adding a diversified mix of equities. However, once we get to the all-stock portfolio, the party is pretty much over. Unless you have very unusual stock-picking skills, choosing individual stocks increases risk without increasing the expected return. There are many ways to increase risk, but most of them give lower returns, such as casino gambling and lottery tickets. To get higher expected returns along with the higher risk requires leverage. This means borrowing money to invest. Unfortunately, the interest on borrowed money cuts into the expected returns. Many analyses of leverage assum...