Interest rate talk is everywhere, especially with last week’s decision by the Reserve Bank of Australia (RBA) to cut the official interest rate to 2.5%. Many people think that changes in interest rates impact only those who have a mortgage but this is simply not true. Changes in interest rates impact everybody. They influence whether individuals like you and I decide to save or spend or borrow. Or whether businesses, large and small will expand or contract. In this way interest rates impact the direction of the whole economy, impacting the daily lives of you and me.
So let’s start at the start – what is an interest rate? An interest rate is simply the price of money. The lower interest rates are the cheaper it is to borrow money and spend it and the less attractive it is to save money (because you don’t get much return on your savings). The converse is true of high interest rates which make it more attractive to save and less attractive to borrow and spend. Think about it, if interest rates were 15% it is very unlikely that you would want to take out a loan and buy a new house. However, putting your money in the bank where you would get 15% interest would look pretty attractive. In this way the RBA uses the level of interest rates to increase the level of spending or saving to make the economy go faster or slower as required. If the RBA thinks the economy is growing too fast they will raise rates to make it more attractive to save and slow borrowing. If growth in the economy is slowing then the RBA will cut rates to increase the attractiveness of borrowing and to cut savings. At the moment the RBA are cutting rates as they are concerned about the economy slowing and so are trying to get us all to save less and spend more.
Things to watch out for in a low interest rate environment:
- If you are looking to borrow you must always remember what goes down must go up! Yes interest rates have gone down recently but when low interest rates do their job and the economy picks up, interest rates will inevitably start to rise. Don’t be tempted by the current low rates to borrow to the max. Yes, take advantage of low rates but always stress-test your repayments to make sure that you can still make them at higher levels of interest rates. For example, when we bought our house back in 2008 (just before the Global Financial Crisis hit), we were paying around 9.5% on our mortgage. That meant an extra $1,500 on our repayments per month compared to what we are paying now. A decent chunk of change!!! Mortgage rates could easily get up to these levels again, so be prepared. Click here to check out a mortgage calculator to make sure you will be ok when rates start to rise.
- Low interest rates are a gift to borrowers – so use it wisely! The RBA would like you to take the money you save on your mortgage repayments and spend it. A wiser idea might be to keep your repayments the same so you pay off your mortgage faster (provided you are comfortably making your repayments at current rates). The latest rate cut reduces repayments by about $50 per month on a $300,000 mortgage. This seems only small but it can cut years off your mortgage. Click here to check out a calculator which shows what a difference a small increase in repayments can make over the life of your loan.
- Maybe it is time to consider fixing part or all of your home loan. See my post next week on the pros and cons of such a strategy.
- Savers need to make their savings work harder. If you are a saver, good returns are becoming harder to come by and it becomes more crucial to assess all your options and make sure you are getting the best possible rate for your savings. Click here to check out my post on what to look out for when choosing an account.
- Savers don’t chase returns. In a low interest rate environment, returns on savings are generally lower and the temptation to take on higher risk investments for greater return grows. Be very sure you know what you are doing and that you are very comfortable with the increase in risk that comes from higher return investments. For example, taking money out of cash (low risk) and putting it in shares (higher risk) is a big move up the investment risk spectrum. Make sure you understand this is what you are doing and you are comfortable. (Click here to see my post on understanding risk.)
Interest rates are one of the important levers that are used to steer our economy. Everybody should pay attention to changes in rates as they impact the daily lives of every single one of us. Interest rates affect whether we borrow, spend or save. It impacts how easily we find it to get jobs, take holidays or sell our house. It affects individuals and businesses and nearly every financial decision you make. Where are rates going from here? Only time will tell, but I suspect we have seen the last cut for the next few months. How the economy performs from here will determine which way rates go next.
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* Please note this is for your general information only and does not constitute financial advice. Please see a financial planner or accountant to get advice specific to your individual needs.