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Prepare for rate rises

"The question is not if interest rates will rise, but when and by how much?"

It has been more than four years since the Reserve Bank of Australia last increased the central interest rate for borrowers.More surprising is its commitment to the record low rate of 2.5 per cent since A ugust 2013, which again remained unchanged last month.The main question is: What does the future ho ld for borrowers with regards to interest rates?

History confirms that the property market operates in cycles and interest rates continue to operate in a cyclic manner. However, many buyers and sellers in the property market might have forgotten what has happened to interest rates in the pas t, or possibl y it was before their time.

The RBA site confirms that interest rates reached the dizzy height of 18 per cent in 1989.  Putting this in perspective, the RBA then set the central interest rate at a mark more than 700 per cent higher than today’s rate. This wasn’t that long ago.

The question is not if int erest rates will rise, but when and by how much?

There is a danger that borrowers might be conditioned to today’s low interest rates and theref ore rely on them over the long term. A sensible s trategy is t o accept that interest rates will increase in due course and prepare accordingly. One approach is t o calculate the payments at a higher interest rate and make these payments now. The excess payment will reduce the principal and soften the unavoidable blow associated with higher interest rates.

A recent tren d has been the increasing preference for interest-only loans. Coupled with record low interest rates, borrowers have been able to access more capital and buy more expensive homes.

However, when int erest rates do increase their unpaid principal will remain unchanged and place the household under substantial mortgage strain.

A safer approach is to now start to pay down some of the principal in preparation. The concern is that if  mortgage stress is occurring today, imagine what will happen when interest rates rise.

Even though less than half of the residential market has a mortgage, there is an indirect effect on the broader market due to forced sales.Preparation now in the form of slightly higher payments can make a large difference when interest rates rise.

Borrowing money is all about assessing risk. Practically everyone needs to borrow money at some time in their life, however the focus should be on  the conditions associated with the loan. It is of ten surprising that a borrower will take out a variable interest loan when they are uncertain about the future level of repayments.

A savvy borrower will reduce their risk by making extra repayments when interest rates are low and while the y can afford to. Every day now we move closer to higher interest rates.

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