Low interest rates wreak havoc on savings strategies
By Jim Middlemiss • Bankrate.com

Savings rule of thumb: Know the rate environment
Investing in a high-interest-rate environment is very different from investing in a low-interest-rate world. So investors need to pay attention to interest rates, says Julie Sheen, vice-president of term investments at the Bank of Montreal in Toronto.

"People generally buy last year's performance. We certainly see that a lot," says Sheen. Because of the currently low rates, she says, people are "playing the interest rate game" and holding off investing in hopes of higher rates. The problem though, is that over the last few years, rates have hovered in the two to four percent range, meaning they're still waiting for higher rates.

A year ago, people were "convinced 2003 was the year of the rising long-term interest rate. By the end of the year, we are right where we started," says Sheen.

So what should you do? Well, a flat yield favors shorter-term investments. "They tend to be more attractive," she says. However, before making a commitment, "you need to go back to the starting point and figure out what it is you're saving for." That sets your investing time horizon and allows you to develop a strategy to meet your goals.

She says fixed-income investors tend to be "heavy savers, and they should be taking the prudent and conservative approach and not try to time the interest rate cycles."

GICs vs. Bonds? Let the rate environment guide you
In a low-rate environment, one investment to consider is a cashable guaranteed investment certificate (GIC) with an escalating rate. That way, if rates spike up, you can cash out and reinvest the money at a higher rate. If rates rise slowly, the escalating feature allows you to keep pace.

In a high-rate environment, where interest rates look to decline, longer-term bonds are more appealing. That's because they will actually rise in price as interest rates drop, since investors are attracted to the higher payout.

The best strategy for either environment, however, remains laddering, says Sheen. That means building a "well-diversified portfolio of fixed-income investments of GICs or bonds" with maturity dates spread out over five years so that 20 percent of the portfolio comes due every year and can be reinvested.

That way, she says, investors ride the interest rate as it rises and falls. They catch the upside when rates rise.

Low rates: Not great for savings, but good for getting rid of debt
While a low-interest-rate environment can play havoc with your investments, it also presents an opportunity to leverage your cash flow, says Frank Zeppieri, a chartered accountant and certified financial planner with the Investment Planning Council in Thornhill, Ont.

"A lot of clients don't pay attention to minimizing the cost of credit and increasing their cash returns," he says. But shuffling or reducing debt can have the same impact as investing in a high-yield bond.

For example, if you have a $10,000 Visa debt at 18 percent and a $10,000 bond paying two percent, you're better off cashing the bond and paying off the debt. That's because you would pay $1,800 in interest in a year, but make only $200 on the bond, a difference of $1,600.

"You want to convert high-cost debt into low-cost debt," says Zeppieri. With interest rates low, it's also a good time to consolidate debts. You can refinance your consumer debt by rolling it into your mortgage. Because that's a secured loan, you'll get a lower preferred rate and save on interest payments. You'll also likely lower your monthly payment, which frees up cash flow you can apply to your debts or investments.

Not only should you use low-rate environments to pay down non-deductible debt, but "you should also try to turn non-deductible debt into deductible debt," says Zeppieri.

For example, if you have $80,000 left on your mortgage and $80,000 in your investment account, you should consider cashing those investments and paying off the mortgage. Unlike in the U.S., mortgage interest is not deductible in Canada. However, you can borrow back the $80,000 and use it to buy investments. And because interest on investment loans is tax deductible, in the end you'll have the same amount of debt and investment, but you'll have a deductible expense that can be applied against your income.

The other strategy to consider in a low-rate environment is consolidating your money into a cash-management account that pays a higher interest rate than a standard savings account. You might have to keep a higher balance, but you will get a better rate, says Zeppieri.

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to National Post, Investment Executive and Wall Street and Technology.