Most homeowners and investors are long term borrowers. That is, they will have a mortgage for many decades. We must realise that over many decades, there will be periods where interest rates will be higher than the average and vice versa.
The average standard variable rate since 1959 is 8.20% p.a. Noting that most borrowers enjoy a discount of at least 2% p.a. off the standard variable rate, the long-term average interest rate is circa 6.5% p.a. That’s what we should expect to pay, on average.
I wanted to set out strategies that can help you navigate through high interest rate periods, like we are experiencing now.
Interest rates probably won’t stay this high for a long time
Interest rates are used as a monetary policy tool to either expand or contract an economy. Interest rates are increased to cool the economy, including consumer demand. As such, higher rates will eventually have that desired effect (to cool inflation) and once they do, the RBA will be able to cut rates.
Over the past 40+ years (refer to the below table), interest rates have remained at the peak level for between 4 and 16 months, with the average time being 10 months.
However, given much higher household indebtedness (compared to the ‘80’s and ‘90’s) and that the standard variable rate is relatively high already (second highest it’s been over the past 26 years), I don’t expect the peak interest rate will need to remain in place for longer than 6 months – I’ll expand on this more later.
Therefore, whilst borrowers will need to navigate higher interest rates, they probably only need to do so for a relatively short amount of time.
Use buffers. That’s what they are there for
We must take advantage of times when interest rates are lower than average by building financial buffers, such as accumulating cash savings in an offset account. This helps us prepare for the inevitable times when interest rates are above average. Australian borrowers have certainly done that over the past few years. Household savings have blown out to be equivalent to 20% of household incomes.
I have made the point over past few years that interest rate expectations can change very quickly. We witnessed that last year. At the beginning of 2022, virtually no one expected rates would rise so quickly over the past year. It is entirely possible that once inflation is under control, that markets will begin factoring in several rate cuts.
Therefore, if you need to eat into your savings to help you through this period of higher interest rates, then do so, as that’s exactly what savings are for.
Reduce discretionary spending
Recently, a lot of inflation has been driven by demand for services. That includes things like holiday travel, medical services, rent and restaurant meals. Some of these items are discretionary. Therefore, if we all reduce our spending, it will help get inflation under control as soon as possible.
Of course, the first thing you should do to position yourself to manage higher loan repayments, is minimise discretionary expenditure as much as necessary. The easiest way to do that is to transfer a set amount of money each week, fortnight or month into a dedicated ‘discretionary expense account’ and pay all your discretionary expenses from there. This will help you to be more conscious about your spending patterns without needing to track every transaction. I’ve discussed this account structure previously here.
Explore ways to increase your income
Of course, increasing your income will help you afford higher loan repayments. That might include pursuing a new role with your existing or a new employer, increasing the amount of time you work, retraining, getting a second job and so on. The labour market is very tight with an unemployment rate of only 3.5%, so employees are well positioned to ensure they are being fairly remunerated.
If you have large leave balances (such as annual and/or long-service-leave), you can ask your employer to pay these out in cash.
Eliminate expensive repayments/financial commitments
Repaying loans with cash savings can substantially reduce your monthly expenses. For example, if you have a HELP debt and earn more than $150,000 p.a., 10% of your gross income will be going towards repaying this debt, which really equates to over 14% of after-tax income.
Using savings to repay HELP debt, car loans, personal loans and so forth can greatly improve your regular cash flow.
If you can, refinance and reset loan terms
The shorter the loan term, the higher the repayments. For example, if I established a $1 million investment loan 10 years ago that has just converted to principal and interest repayments (because I’ve already had two 5-year interest-only terms), my repayments will be $7,455. That’s because repayments are spread over the remaining term, being 20 years. However, if I reset the loan term back to 30 years by refinancing with my current lender (or switching to a new one), my monthly repayments will reduce to $6,320, saving me $1,135 per month.
If you have borrowed too much, face the brutal truth
I have always advised borrowers to prepare their numbers assuming an interest rate of around 6.5% p.a. Any borrowings must be comfortably affordable at this level.
If you don’t think you can service your existing debt if interest rates were to remain at 6.5% p.a. for a long period of time, then it might be a sign you have over-borrowed. If so, you must face this truth, no matter how difficult it might be, you must formulate a plan to reduce your debt levels. This might include selling property. You are better to do it now than risk hanging on too long. If you find yourself digging a hole, stop digging.
Cash flow crush is upon us
The two charts below, provided by CBA, which is Australia’s largest mortgage lender, illustrates how much cash flow will be absorbed by higher loan repayments over the rest of 2023.
The chart on the right-hand side shows the number of borrowers whose fixed rate will expire and roll over onto a much higher variable rate (green bars). Most of that will happen over the rest of 2023.
The chart on the right-hand side shows the difference between interest charged and scheduled repayments. The reason there is a gap is because higher interest rates apply a couple of weeks after the RBA hikes. However, scheduled (P&I) repayments are not recalculated every time interest rates are changed – there tends to be a 3-month lag.
The upshot of this representative data is that consumers will feel the full pinch of higher interest rates by the end of 2023. Hopefully, that will be enough to curtail inflation so that the RBA can begin cutting interest rates in early 2024, if not sooner.
We have enjoyed lots of spare cash flow over 2020 and 2021 with super-low interest rates but those days are over now. It’s time to recalibrate our spending to more normalised levels.
