We all love the thought of low-interest rates generally because for us consumers it effectively lowers the cost of our monthly loan repayments. But what if what you gained on the front end, you were losing on the backend?
If you consider yourself a new home buyer, investor, business owner or retiree on a fixed income, then the story around low-interest rates may be quite different and potentially, you don’t even know it.
The reason for this is that the hype around low-interest rates only tells you one side of a two-sided story.
You borrow money from the bank in the form of home, business, personal and credit card loans which is how you can benefit from low-interest rates. But then you lend back to banks in the form of savings accounts and term deposits.
The problem is that the banks have the greater control on both sides of these transactions and, as we mentioned in a previous article, banks have to keep their shareholders happy.
This means that when interest rates are low the banks tend to hit their cost of borrowing, i.e. the saving accounts and deposits accounts, first and harder.
The knock-on effect of low rates on these accounts is complicated. However when you dive in it blows away these myths that banks and media will have us believe.
These myths actually create an uncertain future for Australians and often catches you unprepared when rates start to rise.
These myths include:
Myth #1 – Low-interest rates are good for home buyers & the property market, however:
- Low investment returns do not assist those trying to save for a first home.
- Low-income growth (low wage inflation) goes hand in hand with low-interest rates as businesses struggle to raise salaries in a low spending environment.
- Low-interest rates can stimulate overdevelopment in the late stages of the property cycle, leading to a correction in an asset class that is highly geared. This can hurt consumer confidence.
- Low-interest rates tend to suppress residential property rental income yields once property prices have inflated. So property investors who purchased when rates were higher, benefit at the expense of non-homeowners and future investors.
- Let’s also not forget that low-interest rates mean money is cheap to borrow, which can promote unsavoury investment and lending behaviour. This was a significant contributor to the 2007 GFC.
Myth #2 – Low-interest rates are good for business
- Lower rates reduce revenue for businesses. Consumers relying on interest and fixed income investment returns have their income reduced which means less disposable income to spend.
- Low-interest rates mean that business cash assets are returning a lower income.
- If the business has little to no debt then the business saves very little interest payments, and business loans tend to have stayed high relative to home loans.
- Low-interest rates tend to be counterbalanced in other areas of the economy like property prices which means expansion opportunities may, in fact, require business to borrow, commercial property investments have appreciated dramatically.
Myth #3 – Low inflation is good for pensioners and Australians on a fixed income.
Whilst low inflation typically means low prices for retirees and pensioners, people relying on fixed income are seeing lower income from deposit accounts which means they have less to spend ultimately making it tougher to maintain their standard of living. Indexing on government transfers/pensions often lags the cost increases on necessities such as energy bills and healthcare spending.
Pensioners and retirees often have a different basket of goods to those measured by inflation, therefore, their actual cost of living may increase faster than inflation rates. This further magnifies the impact of the reduced income they receive from the lower interest rates paid on deposits.
WHY RAISING INTEREST RATES CAN BE BENEFICIAL
To a point, a rise in interest rates from their current levels can actually have a long term benefit to Australians. The issue is how to determine the optimum level of the rates for such a diverse economy and how to inch our way there.
This is the harrowing job that the RBA and the governments of Australia have through direct interest rate adjustments and economic policy.
It is much more difficult than just turning up the thermostat on the car heater. Or perhaps it is as difficult if you have two different people in the car, one too hot and one too cold to start with!
Despite this, it’s fair to say that at some point we can expect to see some increase to interest rates. Therefore it’s important to know how to position yourself financially to capitalise from any the change.
Some ideas include:
- Reduce long-term debt and/ or be prepared to potentially fix some of your loans as this will impact your cost of living significantly as you carry these debts through a series of rate rises.
- Review your portfolios to see what types of investments/companies you hold perform better in high interest rate environment. It's also wise to see where your income is coming from now and how this can be optimised in this low-interest rate environment.
- Restructure your debt to maximise the tax efficiency of the loans. Where you have investment loans which provide you with some deductibility for the interest costs, it’s worth investigating options to restructure your finances so that you maximise the proportion of your debt into deductible loans.
- If you’re on a fixed income like a pensioner, determine what your needs are for cash at call so you can potentially capitalise on rising rates through other investments.
- Should you be looking to buy a home, then increase your allocation to your home deposit fund to speed up the saving towards your home deposit.
- Keep short-term debt like credit cards at a minimum and paid down monthly. These are the higher cost forms of debt and this will impact your cost of living significantly if you carry these debts through a series of rate rises.
Assessing your circumstances and how to position yourself for these potential challenges is not always easy, and you may require some assistance or advice.
An RSM Investment Specialist can assist you in assessing your current situation and expose to interest rates, help you clarify your financial goals and assist you in creating an optimised financial plan.