As interest rates go up, it’s time to reassess how much debt your household can carry
With interest rates rising, it’s a good time to renew interest in how you allocate capital between debt repayments, savings and investments. Photo by Getty Images Have you made up your 2023 intentions? If not, one of the key topics to consider is how much debt your household should carry.
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Like corporations, there is a sweet spot for how much debt is optimal. And especially as mortgages come up for renewal, it’s a good time to renew interest in how you allocate capital between debt repayments, savings and investments.
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Mortgage decisions The biggest liabilities for most families are mortgages. As interest rates go up, this will impact how much of a mortgage a household can comfortably carry.
I suggest an important consideration is the stability of family cash flow. Is there a risk of reduced household income in the foreseeable future?
The second factor is the collective tolerance for uncertainty. Financial markets expect central banks to pivot by lowering interest rates once inflation is under control. However, should inflation prove to be more resilient, how would the household finances be impacted by a sustained mortgage rate of five or six per cent?
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Article content Insurance for disability or critical illness is another important consideration in times of uncertainty. Should an unexpected event happen to a breadwinner’s job or income potential, can the family comfortably service its current debt obligations?
Emergency funds It’s always great to have a rainy day fund. An accepted standard in financial planning is three months of one’s salary, but the amount really depends on the liquidity needs of the household.
For some households, there may be enough liquidity in short-term investments and savings to cover debt obligations and sustain ongoing expenses.
But to account for events such as unemployment, especially if you think it will take longer to find an opportunity with comparable pay, it might make sense to save more.
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Article content Investments Investments are one of the best ways to keep up with inflation and make sure your purchasing power is not eroded over time.
There are different types of investment options depending on your objectives. We know fixed income is fixed, meaning you have locked in your investments at a certain rate. Unless the issuer is bankrupt, you will get your invested capital back plus interest income. This can be a good option for some, especially when interest rates are high.
Household makeover: a financial success story to show how you can live within your means Forget the corporate PR campaigns, here’s how to really save on groceries But if inflation rises or persists, fixed income alone will make it difficult to keep up with a higher cost of living. During the hyperinflation period of the 1970s and 1980s, equities were the asset class that kept up with inflation, but it was a volatile ride since the stock markets reflected the worries in the economy.
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People have different orientations when it comes to risk tolerances and time horizons, so it’s best to seek out advice from someone who understands your goals, objectives and intentions, and plan accordingly.
As you can see, how much debt to carry for is not a standalone question. There is always a need to balance risk management, liquidity and investment objectives.
Rita Li is an investment adviser with RBC Dominion Securities, RBC Wealth Management.
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