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!

Residential Property Investment – Barriers > What if Interest Rates Goes Up?

Okay, Here’s the first one of the fears!
What if Interest Rates Goes Up?

If you are scared of interest rates going up then the solution is to fix it. Just remember that interest rates can both go up and down. Fixing the interest rate reduces the risk that you will have to pay more interest in the future (i.e. guarantee that your interest expense is constant over the period) However, if interest rate drops and you have fixed it then you won’t get any benefit of the interest savings. A suggestion is to fix half the loan so that you can get 1/2 the benefit of interest movement in either direction.

Most people think are scared that interest rates, fixing interest rates will only guarantee that your expense is known (ie. it will not increase or decrease). The factor to note when fixing your interest rates, especially in the more recent economic time (2008) when interest rates all over the world has dropped dramatically, is that fixed rate break cost will go up approximately proportional to the interest savings from the rate drop.

Remember that Banks lend money based on your current financial situation, so as the financial situation improves (e.g. interest rate drop) you would benefit, however if the financial situation deteriorate (e.g. interest rate rise) you would suffer. That is why some people prefer the certainty of being able to service the interest payments through good times or bad times (assuming their financial situation does not change through time)

So think about this the next time you think about fixing your interest rates!

Residential Property Investment – Barriers > What if Interest Rates Goes Up?

Residential Property Investment – Barriers > What if Interest Rates Goes Up?

Okay, Here’s the first one of the fears!
What if Interest Rates Goes Up?

If you are scared of interest rates going up then the solution is to fix it. Just remember that interest rates can both go up and down. Fixing the interest rate reduces 1/2 your risk (ie. it reduces the risk that you will have to pay more interest in the future) and guarantee that your interest expense is constant over the period. Obviously if interest rate drops and you fixed it then you won’t get any benefit of the interest savings. A suggestion is to fix half the loan so that you can get 1/2 the benefit of interest movement in either direction.

Most people think are scared that interest rates, fixing interest rates will only guarantee that your expense is known (ie. it will not increase or decrease). The factor to note when fixing your interest rates, especially in the more recent economic time (2008) when interest rates all over the world has dropped dramatically, is that fixed rate break cost will go up approximately proportional to the interest savings from the rate drop.

Example:
Loan Amount: $300,000
Fixed Interest Rate: 8%
Fixed Term: 2 years
Current Interest Payable: $24,000

If interest rates dropped 2% from 8% to 6%, a person on variable loan would save $6,000 (2% x $300,000) in interest payments (ie. instead of paying $24,000, they would now pay $18,000 @ 6%)

If you were to break your fixed rate loan with 2 years remaining, a fee of approximately $6,000 x 2 years = $12,000 would be charged to break out of the fixed rate loan. This would effectively make breaking your fixed rate loan not worthwhile. (Note: the actual break fee depends on the prevailing cost of funding for the bank and not the interest rate that is advertised on the loan, though it is a good approximation)

The upside here is that when the bank gave you the loan at 8% you were able to service the debt and if your financial circumstances hasn’t changed, then you would still able to service the debt without. Personally, the large interest rate drops have affected my fixed loans and there is not much I can do about it. That said, if I had a choice to rewind time, I would have fixed my loans. Personally I prefer the certainty of knowing that my expenses are fixed than hoping for a chance of interest rate drops.

Here’s a link to some resources on Real Estate

Residential Property Investment – Barriers > What if Interest Rates Goes Up?