{"id":2958,"date":"2022-07-03T10:01:51","date_gmt":"2022-07-03T10:01:51","guid":{"rendered":"https:\/\/royabhishek.in\/urbanbuyer\/should-you-do-anything-about-rising-interest-rates\/"},"modified":"2022-07-03T10:01:51","modified_gmt":"2022-07-03T10:01:51","slug":"should-you-do-anything-about-rising-interest-rates","status":"publish","type":"post","link":"https:\/\/royabhishek.in\/urbanbuyer\/should-you-do-anything-about-rising-interest-rates\/","title":{"rendered":"Should you do anything about rising interest rates?"},"content":{"rendered":"

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Key takeaways<\/p>\n

Some investors have been spooked by the RBA hiking interest rates by 0.75% over the past two months, but most commentators feel that a rate of 2.60% by March 2023 is too high and unlikely to happen.<\/p>\n

The RBA will have to cut rates by 0.50% in the second half of 2023 if prices continue to rise because higher prices will dampen consumer and business confidence, which will cool economic growth.<\/p>\n

Standard variable interest rates will still be very low by historical standards, and even if the RBA hikes rates by 1.40-1.50% as the banks expected, standard variable interest rates will still be below the long-term average.<\/p>\n<\/div>\n<\/div>\n

Some investors have been spooked by the RBA hiking interest rates by 0.75% over the past two months, particularly since it has spent the past two years telling us that rates would not rise until 2024.<\/p>\n

Higher interest rates at the same time as rising prices (inflation) are a two-fold blow to household budgets.<\/p>\n

\"Interest<\/p>\n

Where are interest rates heading?<\/span><\/h2>\n

The banks predict that the cash rate will rise by a further 1.40% to 1.50% by March 2023.<\/p>\n

Money markets<\/a> have priced in a cash rate that is more than 2.60% higher by March 2023, but most commentators feel this is too hawkish and unlikely to happen.<\/p>\n

The theory is that, due to higher inflation, the cash rate should return to the neutral rate as soon as possible to avoid monetary policy adding to inflationary pressures.<\/p>\n

The neutral rate is when the cash rate is neither economically expansionary nor contractionary.<\/p>\n

Most commentators believe the neutral rate is between 2% and 3%.<\/p>\n

Ironically, inflation may force rates to fall again<\/span><\/h2>\n

Australian inflation is currently 5.1% p.a. and will certainly read higher in the June quarter.<\/p>\n

Inflation in other developed economies is approaching 10%.<\/p>\n

But anyone that\u2019s visited a supermarket or petrol station lately knows that inflation is a lot higher than what the CPI measure reflects.<\/p>\n

This higher inflation has already dampened consumer and business confidence, which will cool economic growth (GDP).<\/p>\n

The neutral cash rate might very well be between 2% and 3% when prices of goods and services are at normal levels.<\/p>\n

However, given the backdrop of much higher prices, it is very likely that the natural rate is closer to 1% to 1.5%.<\/p>\n

Therefore, if the RBA raises rates too far at the same time prices are very high, it will result in a decline in economic growth (GDP).<\/p>\n

In fact, last week CBA forecasted that will happen and the RBA will cut rates by 0.50% in the second half of 2023.<\/p>\n

Don\u2019t overreact to recent rate rises<\/span><\/h2>\n

I was watching TV with amusement last week.<\/p>\n

Reporters were interviewing people about the RBA\u2019s recent 0.50% rate hike.<\/p>\n

People were talking like interest rates were 10%!<\/p>\n

Of course, I shouldn\u2019t be surprised at the alarmist nature of TV!<\/p>\n

The reality is that interest rates are still very low by historical standards.<\/p>\n

\"Interest<\/p>\n

By the end of this month (i.e., after the most recent rate hike filters through to mortgage rates), standard variable home loan (P&I) rates will be around 4.75% p.a. and investment (IO) rates approximately 6.10% p.a.<\/p>\n

Of course, new borrowers are offered hefty discounts of 2% p.a. or more off the standard variable rate.<\/p>\n

Therefore, most discounted home loan rates will be in the high 2% to low 3 %s.<\/p>\n

The average standard variable rate over the past 20 years was 6.36% p.a. according to RBA data.<\/p>\n

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And 20 years ago, the average interest rate discount was only 0.70% p.a., so the actual average discounted rate would be closer to 5.50% p.a.<\/p>\n

Therefore, even if the RBA hikes rates by 1.40-1.50% as the banks expected, standard variable interest rates will still be about 1% below the long-term average.<\/p>\n

Avoid fixed rates for now<\/span><\/h2>\n

The fixed rates that the banks offer customers are dependent upon the banks’ cost of funds e.g., how much it costs them to borrow for 3 years.<\/p>\n

Given that the interest rate curve<\/a> is unrealistically steep, which makes borrowing more expensive for the banks, fixed rates are financially unattractive.<\/p>\n

For example, 3-year fixed rates are high at 4% and 5-year fixed rates are typically above 5% p.a.<\/p>\n

Two things may occur over the next year that will put downward pressure on fixed rates.<\/p>\n

Firstly, the interest rate yield curve will eventually adjust to something closer to reality.<\/p>\n

Secondly, if the market expects that the RBA will have to cut rates next year, fixed rates may fall.<\/p>\n

Therefore, my general advice to borrowers is to remain variable for now and consider fixing next year, depending on rates, of course.<\/p>\n

If your loans are fixed, prepare for higher rates now<\/span><\/h2>\n

If you were lucky (smart) enough to fix your interest rate last year, it is entirely possible that your interest rate is below 2% p.a.<\/p>\n

You will need to prepare for when your fixed-rate matures and the interest rate reverts to the variable, which is almost certainly likely to be higher.<\/p>\n

I suggest borrowers manage their cash flow as if their interest rate was variable.<\/p>\n

\"Interest<\/p>\n

For example, if your loan is $1 million, your monthly interest cost would be $1,670 if your fixed rate was 2% p.a.<\/p>\n

However, if your loan was variable and consequently your interest rate was, for example, 3% p.a., your monthly interest cost would be $2,500.<\/p>\n

Therefore, I recommend that you start putting aside $830 per month (in savings) in preparation for higher interest rates.<\/p>\n

How do higher rates affect investment holding costs?<\/span><\/h2>\n

When contemplating borrowing to buy an investment property (or home), you must consider whether you will be able to afford to meet holding costs when interest rates rise.<\/p>\n

I tend to advise clients to prepare their calculations based on an interest rate of 6% to 6.5% p.a.<\/p>\n

Of course, interest rates are currently a lot lower than that, and may not rise above 6% p.a. for a long time, but it\u2019s prudent to be conservative.<\/p>\n

The table below estimates how much it will cost to hold an investment property on an after-tax basis (i.e., including negative gearing).<\/p>\n

I have profiled two-property scenarios: an apartment for $750,000 generating a gross rental yield of 3% and a house for $1.5 million generating a gross rental yield of 2%.<\/p>\n

\"Fig02\"<\/p>\n

If you have any concerns about whether these holding costs are affordable, then you must consider reducing your budget or not investing in property.<\/p>\n

Rising interest rates<\/span><\/h2>\n

Interest rates are certainly on the rise but are expected to remain below the long-term average.<\/p>\n

And if prices of goods and services remain alleviated (mostly due to\u00a0supply chain issues<\/a>), it is very possible that interest rates will need to be reduced again.<\/p>\n