With the Global Financial Crisis and interest rates falling to all time low for many countries all over the world it is obvious that certain investments that were not viable during a high interest environment is now possible with cost of funding (i.e. interest rates halving or more)

With low interest rates many people are also opting for variable loans instead of fixed loans, especially since fixed rates are sometimes quite a bit more higher than the variable rates. The combination of low interest rates and investors taking advantage of the low interest environment can lead to a financial disaster if not planned properly…

Why you might ask? well it’s very simple, if interest rates increase the repayment amount would obviously increase except it will hurt the investor a lot more at low interest rates (lower base).

For example,

• When interest rates were around 7% and interest rates increased by 0.5% to 7.5%, the investor would have to pay 7.143% (7.5%/7%) more in interest expense.
• However if interest rates are around 4% and interest rates increased by 0.5% to 4.5%, the investor would have to pay 12.5% (4.5%/4%) more in interest expense!

Hopefully you can see that it’s over 3 times (12.5%/7.143%) the increase in interest expense!

Currently, Australia’s cash rate is 3% with the cash rate traditionally being around 5-6% it would not be a surprise if the cash rate increase over the next few years back to the average of around 5-6% (i.e doubling in interest rates, meaning doubling in interest repayments!)

Graph Courtesy of Forex Blog

So don’t fall for the interest rate trap! Think about the potential increase in interest rates before making any investments especially if you are not able to financially sustain future interest rate rises!

Tags: Interest Rates