Looking into the Crystal Ball of Rates
by Nick Carydias, Senior Mortgage & Finance Adviser
Most people only borrow money to purchase a property or invest in shares when they’re confident they can service the debt into the future, even if rates should rise. Banks, also, are wary: they always factor in a buffer when assessing whether or not a person is in a stable enough financial position to afford the loan they’re applying for.
Affordability is, in fact, an important calculation when considering a possible home or investment purchase, and in that regard:
- You have to be confident about the reliability of your income
- You have to allow for unforseen expenses
- You have to know that you can afford the repayments on your loan even if interest rates rise further down the track
This, of course, is exactly the question everyone’s asking themselves right now – Where are interest rates heading during the next few years? Should we fix our rate, or should we stay with a variable rate?
There’s no definitive answer to this, unfortunately. Even though there’s an abundance of opinions and speculation today, it’s really anyone’s guess as to what’s going to happen to rates tomorrow.
What we do know and what we can look at, however, is the history of interest rates in Australia. If we understand how rates are controlled and what influences them, then we might at least be able to reach an informed decision as to where they might possibly be heading.
Firstly, it’s important to understand how interest rates are determined at. Are they randomly picked or do market forces create the interest rate of the day? In other words, is there any kind of method or system behind the figures that magically appear in the media on a monthly basis?
The reassuring answer is that there is actually a method behind the creation of interest rates.
The Reserve Bank of Australia sets the cash rate (which is the overnight money market interest rate), and the banks and financial institutions then add their margin to that – amounting to approximately 1.5 to 2.5 per cent. This is the final rate at which the banks make personal loans and mortgages available to you, the borrower.
If you have a variable rate home loan then your lender generally increases the interest rate on it by whatever increase the Reserve Bank makes to the cash rate. If the Reserve Bank does the opposite and decreases the cash rate, your bank will likely decrease your rate. (You won’t be surprised to hear that this isn’t always the case. Banks and lenders often don’t pass on, in full, a cut announced by the RBA. It can be just a portion of it.)
What is the RBA and what do they do?
The Reserve Bank of Australia's main responsibility is monetary policy. Policy decisions are made by the Reserve Bank Board, with the objective of achieving low and stable inflation over the medium term.
Other major roles are maintaining financial system stability, and promoting the safety and efficiency of the payments system. The Bank is an active participant in financial markets. It manages the country’s foreign reserves, issues Australian currency notes, and serves as banker to the Federal Government.
Below you will see a graph detailing the history of interest rates in Australia over the last 50 years, up until August 2008, just before rates again started to drop.
As you can see, in the late '80s up until the early '90s, rates were at their highest level ever, hitting a scary 17 per cent. Keep that in mind when considering that last August interest rates were at 9.45 per cent, relative to the 17 per cent back in the 80s/90s, we thought 9.45 per cent was high.
Having said that, there’s one very powerful word in that last sentence which is key to being comfortable with rate moves, and that word is relative.
Many people seem to panic at times like these, allowing themselves to be so overwhelmed and frozen by their dread of rate increases that they’re disinclined to invest their money in anything.
I ask those people to consider this: when rates go up, it almost always means that everything surrounding rates will go up too.
Here I’m talking about inflation, of course. And contrary to popular opinion, inflation is not all bad news. It can mean the economy is stronger, unemployment levels may be lower, rental returns on property probably increase, and salaries will also be on the rise. In other words, rates are always relative to whatever’s going on around them.
So next time you’re looking into your crystal ball and trying to predict the course of rates, just remember to do your financial planning conservatively and correctly. Certainly prepare for the unforseen, but do not allow that to put you off forever from the decision to purchase or invest. You could then well miss out on the gains you’d have made if you’d purchased quality investments.
For more information, or to arrange an appointment with a John Hopkins Mortgage & Finance Adviser, please contact our Client Liaison Officer on 1300 726 082 or click here.