The Impact of Higher Interest Rates
By PAIP Canada staff
When interest rates increase or decrease, there’s lengthy process for the impact to be felt by both individual Canadians and corporations alike.
Beyond the most prevalent reaction of “my mortgage is going to cost more each month” is a much more complex flow through into the economy.
When the Bank of Canada (BOC) increases interest rates, those with variable mortgages will experience an increase in the amount of interest they pay each month. The amount going towards the repayment of principal decreases, but only for so long. Eventually, each mortgage has to be refinanced, or interest rates increase to the point that one’s monthly mortgage payment has to increase to cover the higher cost of borrowing.
In Canada, the large majority of variable rate mortgage holders have already reached that point – interest rates have increased substantially from their lows, resulting in the need to increase monthly mortgage payments for the average Canadian.
Although the impact is no different for commercial mortgages, there are additional factors to consider for companies. First off, when it comes to real estate, the increase in “work from home” has drastically increased the supply of available office space. Dovetailing with this are higher operating costs for landlords due to higher interest rates and wage inflation.
For companies that are not landlords, the higher rates of interest will have a two-pronged effect on their operations. To begin with, since debt was so cheap for so long, many companies will quickly realize that they’re far too leveraged given their sales and equity valuations. As an example, a company with $10 million of debt would incur an interest expense of $200,000 (assuming a 2% rate of interest). After refinancing however, the same company may now have to pay closer to $600,000 (assuming a 6% rate of interest) due to the higher cost of borrowing, yet nothing else has changed in their day-to-day operations. Imagine that, $400,000 has been shifted away from the company’s bank account into the coffers of their lender, simply because the BOC increased interest rates.
For companies looking to expand, the same thought process can be applied. If a company is going to invest its capital in a new project, then the proportion of debt and the proportion of equity may need to be reconsidered. Higher interest rates mean higher interest costs, but at the expense of the bottom line. Why would a company invest additional capital if projected profit has decreased? It’s an awfully difficult thing to justify to shareholders (for publicly traded companies), and probably not something an individual owner would be willing to do with their own money (for private companies).
As much as we don’t want to admit it, higher interest rates have made saving money much more attractive… at the expense of new capital outlays. Essentially, the threshold for new projects has drastically increased, leading many to be delayed or cancelled altogether, but don’t hold your breath for the announcement. It’s similar to a bad experience at a restaurant. Rarely have I ever known anyone who after a bad experience at a restaurant would contact them to confirm that they wouldn’t be coming back for dinner the following week. Clients don’t advise the restaurant that they’re not going back – they just don’t go back. There’s no announcement.
Deciding not to undertake a project is the same thing. Companies rarely announce that they’re not moving forward with an expansion, especially if they haven’t made any hard financial commitments.
Since companies have much more thorough budgets than the average individual, the impact of higher interest rates is only starting to be felt in the C-suites of our companies. As the financing commitments expire and must be renewed at higher rates, companies will become much more selective with projects, just as they will with each new hire. As the economy slows, so too will wage growth. The employment market will eventually rebalance and a certain degree of “normalcy” will return to the market, albeit with higher rates of interest.
As for the average Canadian, ripping off a band-aid is rarely a pleasant experience, but we’re in the process of doing that now. With any luck, once it’s done, it’s done.