Why low interest rates are not a good idea

Today and tomorrow, I will be looking at the pros and cons of the Bank of Canada's decision to keep interest rates low.

Today's posting discusses the reasons against.

If someone is offering you a continuous stream of cash at little cost, what incentive is there to save and not borrow?

Not much. That's what makes the Bank of Canada decision not to raise the benchmark rate - and its hint it won't be doing so in the near future - so disconcerting.

Consumers have been hearing for months and months that "rates are going up" so you had better get your house in order.

They seemed to be heeding the call. A report from credit rating agency TransUnion showed in the second quarter of 2011 non-mortgage debt levels had declined from a quarter earlier. It was the second straight quarter debt levels had dropped.

Now Tom Higgins, vice president of analytics and decision services at TransUnion, wonders whether it will all be for naught.

"The signs that we did see in the last two quarters is that on a quarter-to-quarter basis, it is the first time [debt levels] have gone down in well over six years," Mr. Higgins says. "We may be at a peak."

Mr. Higgins says Canadians had started to clamp down on things. "All the discussion over the last month-and-a-half is, 'They are going up, they are going up', " he says. "Now interest rates aren't going up. So the big question is does that mean next quarter [debt levels] will revert to their old trend and start going up again?"

To put the amount of non-mortgage debt in context: Despite the declines of the past two quarters, each Canadian carries an average debt of $25,597. Four years ago, it was about $19,000.

One of the more interesting trends on debt is the rising number of lines of credit tied to the prime lending rate, something directly affected by Bank of Canada decisions.

Those with lines of credit carry an average outstanding balance of $33,855.

Lines of credit are a growing share of non-mortgage debt, which makes good financial sense considering the outrageous rates one must pay on outstanding credit-card balances.

The good news is delinquencies on lines of credit are falling and remain at a microscopic 0.2% of all loans, TransUnion says.

"The biggest thing driving the lines of credit is it's the cheapest," Mr. Higgins says.

Laurie Campbell, executive director of Credit Canada, says lines of credit have become a great temptation for consumers. "People will see rates are staying low and think, 'I can tap into my line of credit, what a great deal,' " she says.

"I think people have been looking at other forms of credit and [are] recognizing lines of credit are cheaper."

She adds that the temptation to bite off more debt than one might be able to handle extends into the housing market as consumers opt for variable-rate loans tied to the prime rate.

Benjamin Tal, deputy chief economist at CIBC World Markets, says the latest interest-rate decision will give homeowners more confidence that money will continue to be cheap.

"The real estate market seems to have nine lives. Every time interest rates are supposed to go up, something bad happens," Mr. Tal says. "Ironically, the misery of other people is going to help the credit market."

He says Bank of Canada governor Mark Carney may be saying one thing publicly about debt levels but privately hoping consumers continue to spend to boost the economy, even as that means more debt.

"There is no question we need to cut back, but we can't do it cold turkey," he says.

In the interim, Mr. Tal predicts, with no real threat of rates rising, credit debt will go up and the savings rate will likely decline.

"I don't think it'll go back to 12% [growth in credit debt per year] the way it used to be, but you'll see another wave in credit [debt] growth," he says. "The misery of other people will help the Canadian consumer continue to enjoy extremely low interest rates."

That kind of "help" the indebted Canadian consumer really didn't need.

Source: Garry Marr, Financial Post


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