The media is having a field day with a seemingly endless stream of discussion about imminent interest rate rises. Terms such as ‘skyrocketing’ interest rates and ‘tumbling property prices’ making many investors and homeowners fearful. Of course, this is the role of newsmakers and in the property industry, we are no strangers to this sort of fear mongering!
The reality however is far less dramatic. Let’s look at some of the facts, even in the face of the Reserve Bank increasing the cash rate.
Borrowers assessed at a higher interest rate
When it comes time to assess a borrower’s suitability to service a debt, lenders do not assess the loan at the current interest rate you pay, instead they buffer in around 3 per cent, effectively stress testing the borrower’s ability to service the debt should interest rates rise. They use 70 per cent of rental income (assuming 20 per cent vacancy) and then tax that income, assume you have no cash reserves, never take a pay rise, rents never increase, credit cards are to their limits and never repaid and so forth. This means that a borrower should comfortably be able to withstand at least a 3 per cent hike in interest rates before experiencing ‘mortgage stress’.
Current cash rate at historical lows
Currently we have the lowest cash rate in the history of Australian lending. When the pandemic first struck in 2020, many property commentators forecast grim 10 – 30% declines in property values. As a result, the Reserve Bank reduced the official cash rate (which influences lending rates) by 0.65 per cent, to a historic 0.1 per cent, in a bid to stimulate economic activity. The reduced cash rate lowered bank funding costs, leading to record low mortgage rates and capital growth that surged to three-decade highs.
Economists now forecast that the cash rate will likely be hiked 3 or 4 times by the end of 2023, potentially bringing it to around 2.5 per cent, which is still well within the serviceability scenario described above.
So, what measures can you undertake to shield yourself from future interest rate rises?
When establishing your finance structure, seek advice from an experienced property investment advisor/specialist investment finance broker who can ensure you are set up with a cash reserve buffer to help you withstand periods of financial stress. Put simply, additional cash can be borrowed at the time of financing/refinancing and this money is kept aside in an offset account which is linked to your investment loan, with the added benefit of saving you interest over time. Under no circumstances should this buffer be used for anything other than as a risk mitigation strategy.
Fix your interest rate now
Many borrowers are opting to take a fixed interest rate over a variable rate, thereby locking in their current low interest rate for a set period. Given the Reserve Bank is likely to continue increasing the Official Cash Rate it would be prudent to speak to your mortgage broker or property investment adviser about whether fixing rates suits your strategy right now.
Do you want to grow your portfolio? Are valuations relevant for you to enable this? Will fixing a loan restrict your plans? Will you benefit from offset accounts? Will you be selling any properties or coming into any large cash sums? Do you need the repayment certainty, or did you build a strategy for just such an event? What do you save after tax? What loans could you fix Vs. leave variable? It’s often not an all or nothing approach. These are all questions that need to be considered before such a decision can smartly be made.
Fixed rates are based on the Bank Bill Swap Rate and not the Official Cash Rate, hence they have increased approximately 1 per cent since October last year in line with international markets, and now sit around 2 per cent higher than a variable rate with offset. An Interest Only (IO) variable investment loan can be had for 2.8 per cent today while a similar fixed rate 3-year loan on an interest only basis is 4.8 per cent Let’s look at a scenario if variable interest rates were to rise 2 per cent in the next 12 months v/s fixing a loan now for 3 years.
$1,000,000 fixed 3 years at 4.8 per cent IO = $144,000 in interest for 3 years (A)
$1,000,000 variable IO today at 2.8 per cent but increasing gradually by 2 per cent over the next 12 months is a blended rate of 3.8 per cent (year 1 $38k or 3.8 per cent, year 2 $48,000 or 4.8 per cent, year 3 $50,000 or 5 per cent) = $136,000 over the three years (B)
Whilst variable rates offer more flexibility in repayments, refinances, restructures, and offset accounts (which are worth 0.15-0.2 per cent) so the decision is not simple, and a tailored one.
Use your lazy equity
The media refers to ‘the property market’ as a single entity. The reality is there are many hundreds of property markets in Australia, and each capital city is its own market with its very own market cycle. So, higher interest rates will more so impact the most expensive of those markets, where money does not go as far.
Also, with average incomes roughly the same across the country and property prices in some markets 100 per cent lower than Sydney or Melbourne, it is rational to assume where people will be investing their money, and which markets will dominate growth for the next 7–10-year cycle.
As interest rates increase, history has shown that this translates into higher wages growth and rents paid by tenants as well as lower inflation as people reduce discretionary spending. It also keeps the AUD in check which helps exports. This should make it cheaper to buy than rent in many markets, and it will take years before that happens again for Sydney or Melbourne.
Aided by the fact that property prices all over the country have risen some 20 – 30 per cent over the past 12-24 months, many people are now sitting on what we term as ‘lazy equity’. You can opt to refinance your property, taking out some of the equity to reinvest in another property in a high-growth area with strong rental yields and growth forecasts and/or put the remainder of the equity you unlock into your cash reserve buffer to mitigate future risk, including future interest rate rises.
Talk to your property investment advisor about creating your very own tailored investment plan that allows you to navigate the future ‘what-ifs’ safely, while creating wealth over the long term.