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. Higher interest rates at the same time as rising prices (inflation) are a two-fold blow for household budgets.

### Where are interest rates heading?

The banks predict that the cash rate will rise by a further 1.40% to 1.50% by March 2023. Money markets 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.

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. The neutral rate is when the cash rate is neither economically expansionary nor contractionary. Most commentators believe the neutral rate is between 2% and 3%.

### Ironically, inflation may force rates to fall again

Australian inflation is currently 5.1% p.a. and will certainly read higher in the June quarter. Inflation in other developed economies is approaching 10%. But anyone that’s visited a supermarket or petrol station lately knows that inflation is a lot higher than what the CPI measure reflects. This higher inflation has already dampened consumer and business confidence, which will cool economic growth (GDP).

The neutral cash rate might very well be between 2% and 3% when prices of goods and services are at normal levels. However, given the backdrop of much higher prices, it is very likely that the natural rate is closer to 1% to 1.5%. Therefore, if the RBA raises rates too far at the same time prices are very high, it will result in a decline of economic growth (GDP). In fact, last week CBA forecasted that will happen and the RBA will cut rates by 0.50% in the second half of 2023.

### Don’t overreact to recent rate rises

I was watching TV with amusement last week. Reporters were interviewing people about the RBA’s recent 0.50% rate hike. People were talking like interest rates were 10%! Of course, I shouldn’t be surprised at the alarmist nature of TV!

The reality is that interest rates are still very low by historical standards. 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. Of course, new borrowers are offered hefty discounts of 2% p.a. or more off the standard variable rate. Therefore, most discounted home loan rates will be in the high 2%’s to low 3%’s.

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

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.

### Avoid fixed rates for now

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. Given that the interest rate curve is unrealistically steep, which makes borrowing more expensive for the banks’, fixed rates are financially unattractive. For example, 3-year fixed rates are high 4%’s and 5-year fixed rates are typically above 5% p.a.

Two things may occur over the next year that will put downward pressure on fixed rates. Firstly, the interest rate yield curve will eventually adjust to something closer to reality. Secondly, if the market expects that the RBA will have to cut rates next year, fixed rates may fall.

Therefore, my general advice to borrowers is to remain variable for now and consider fixing next year, depending on rates, of course.

### If your loans are fixed, prepare for higher rates now

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. You will need to prepare for when your fixed rate matures and the interest rate reverts to variable, which is almost certainly likely to be higher. I suggest borrowers manage their cash flow as if their interest rate was variable.

For example, if your loan is $1 million, your monthly interest cost would be $1,670 if your fixed rate was 2% p.a. 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. Therefore, I recommend that you start putting aside $830 per month (in savings) in preparation for higher interest rates.

### How does higher rates affect investment holding costs?

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. I tend to advise clients to prepare their calculations based on an interest rate of 6% to 6.5% p.a. 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’s prudent to be conservative.

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

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

### Rising interest rates

Interest rates are certainly on the rise but are expected to remain below the long-term average. And if prices of goods and services remain alleviated (mostly due to supply chain issues), it is very possible that interest rates will need to be reduced again.