We knew the super low interest rates of last year weren’t going to be here forever, but the speed with which they are snapping back has been surprising.
So in this weeks episode I wanted to canvas some of the issues I’m talking with clients about right now when it comes to the impact of higher interest rates.
For those with a mortgage
An approach we take here is to hope for the best but plan for the worst.
The best, if you’re a mortgage holder, is that rates rise no more than 2% from here, and then start coming down again late next year or early 2024. This is the current market forecast, but of course, no one knows what the future holds.
It’s important then for your planning to recognise that the best case is that interest rates are about 2% higher than they are today and they stay that way for a year to 18 months. The emphasis here is on best case, just in case you missed it.
So that’s the outcome we hope for and as a starting point you need to ensure that this is a scenario you can manage through. Use the mortgage calculator on the Moneysmart website to check what your mortgage repayments will be with rates 2% higher than they are today, and if you’re current payments need to go up, consider doing that now to be ahead of the wave.
With the best case covered off, now let’s think about the worst case. If you’ve read the Financial Autonomy book you will know that one of the strategies canvased in there is worst case scenario planning. This is where you think ahead to bad scenarios that are unlikely to happen, but not impossible, and you consider what you would do if they were to unfold. Knowing that you have a solution in your back pocket to a potentially significant unpleasant event can relieve a lot of stress. So let’s apply that here.
I think there’s two possible worst cases that we should consider. The first is that rates go a lot higher from here and that they stay that way for longer than expected. So for the purposes of our worst case planning let’s consider rates 5% higher than they are today, and staying that way for three years. The good news with this scenario is that in order for it to unfold, the economy would have to be absolutely ripping. That means there’s a very high chance that you’ve got a job, and you will probably be seeing some significant pay rises. Use the Mortgage calculator once again to understand what your repayments would be at this higher interest rate. Are your current repayments enough to cover this? If not there’s no immediate need to make any changes. This is an unlikely scenario to unfold. But the purpose of this exercise is just to think through what you would do if it happened.
One starting point would be to renegotiate the length of your loan. If you look at your online banking you should be able to see the remaining term on your loan. You could go to the bank and get them to rework it for a new term, likely 30 years. Stretching out the length of the loan will reduce the required repayments and perhaps make them affordable at the higher interest rate. There’s actually not a lot of downside to making this change because of course you can always make higher repayments and still get the loan paid off on your current schedule. But it certainly provides some flexibility.
If you currently do any salary sacrifice to superannuation, this could be suspended, freeing up cash to meet your additional loan repayments.
Cancelling the annual family holiday could be another thing you could have in this worst case scenario plan. Again, something you hopefully won’t need to do, but it’s helpful to know that if you normally spend $10,000 a year on an annual holiday, well if things got really tight that’s money you could use to take the pressure off on the mortgage front. As much as we all love our holidays and need a bit of rest and recuperation, a roof over our head must take priority. Think about any other discretionary spending like this that you could put off in this worst case situation.
I said earlier that there were two possible worst case scenarios we should consider. We’ve covered off the higher and longer rate scenario, but another case we should consider is the harsh recession scenario.
Stock markets are down compared to where they were a year ago not because company profits have declined, but because investors are worried about what 2023 might hold. Central banks are trying to slow down the economy with higher interest rates, but it’s a blunt tool with lagged impacts. It’s completely possible that they go too far or alternatively that in order to achieve their aim of bringing down inflation they are forced to engineer an economic contraction. I’ve specified here the worst case being a harsh recession. This is because a mild, short term recession is quite probable in 2023. This is not a huge issue. We had a mild recession during the pandemic, and few of us felt any impact.
The one we need to plan for then is a case where unemployment shoots up, to 10% or more from its current 3.5%. If you remain employed, the good news in this scenario is that interest rates will fall pretty quickly. But if you lose your job this is not much comfort. So in your worst case scenario plan think about what you would do if you lost your job. Have you got cash reserves to see you through? Would you need to sell your home and rent? Is there any training or skills development you could do right now to help maximise your employability? Again, the idea with this worst case scenario planning is to give you the peace of mind that if the unlikely but unpleasant were to occur, you have a pathway through to the other side.
Record your worst case scenario plan somewhere convenient to you. I do it in Trello, but use the tool that suits you. In all likelihood you’ll never need it, but the peace of mind gained from knowing that you have a solution should times get challenging, is enormous.
Okay, so you’ve checked that you’re in good shape right now in the best case and most probable future scenario, and you have some ideas as to how you would handle things in a worst case scenario. What other things could you be doing to help manage through this period?
The most obvious is to tighten the belt wherever possible and accumulate savings in your offset account. If you need help with your budgeting, the Budget Planner tool on the Moneysmart site would be a good place to start.
You might also want to look at how you set up your cash flow strategy. If you’re using a bucket strategy and have cash sitting in different accounts earning minimal interest, it could be helpful to swing this money into an offset account. Some banks will even let you have multiple offset accounts so you could replicate your bucket strategy but using entirely offset accounts rather than traditional savings account.
I’ve focused on home loans so far because they are the big debt, but of course rising interest rates doesn’t only affect your mortgage. Any debt you have with a variable interest rate should be focused on and paid off as soon as possible. If you have multiple debts, check their interest rates and go hard in paying off whichever has the highest rate. Once this one is paid off, shift your focus to the next most expensive debt.
Perhaps your mortgage right now is quite manageable however you have plans in place for significant renovations or an extension. The planning for these type of major undertakings often takes years, and so putting them on pause can be a really hard call. It may be prudent however to make this tough call. As canvassed earlier, the most likely scenario is that rates are trending back down a year or so from now, so hopefully the delay will be quite short lived. But today the reality is we just don’t know how high rates are going to go, and so embarking on a project that entails a major debt could be something you want to reconsider.
Let’s change gears now and think about what opportunities might present in a higher interest rate world. The most obvious is that you will get a better return from your cash savings in the bank. Whether that’s enough to keep up with inflation is questionable, but we all need liquidity for emergencies and the like, and in recent years the earnings we’ve received on those savings have been almost non-existent. This opportunity is particularly relevant for retirees or those approaching the stage of life where your mortgage has been repaid and you have a preference for some conservative cash holdings. Things like term deposits for instance. So those with savings are definitely winners in a higher interest rate environment.
We are also experiencing price declines in most assets at present which could present some good buying opportunities. Property prices are coming off as potential purchasers are adjusting how much they can afford to borrow. And the share market has pulled back on worries that these high interest rates will cause a recession in 2023. In both cases, for long term investors in a secure financial position, it’s possible that a once in a generation opportunity will occur over the next 12 months. It requires some bravery for sure, but those who did some buying late in 2008 when the GFC felt like a bottomless pit, have enjoyed some enormous profits in the subsequent decade plus.
You might already have long term wealth creation strategies in place. At the very least you’ve got your superannuation invested and ticking over. Assuming your strategy is well thought out and reflects your time frame, beware of the inclination to tinker or change things in response to this current bout of interest rate rises. Stock and property market volatility is normal, and trying to time both an exit and a re-entry is almost impossible. Research consistently shows that the investors that get the best result are those that leave things alone, tolerating the downs so that they participate in the recoveries. Indeed we’ve seen this recently through the pandemic. In the 2020 financial year Australian shares declined 7.2%. However those that stayed the course enjoyed a bounce in 2021 of 30.2%. Now I’ve got no idea if we’ll see a similar bounce next year to the current market decline, but history shows that investors with a five year plus timeframe derive a consistently good result, certainly in comparison to the alternative of leaving their savings in cash, where its value gets eroded by inflation.
To summarise then, the key Strategies and Opportunities in a Rising Interest Rate World are:
- Hope for the best, but plan for the worst – develop your worst case scenario plan
- Maximise your use of offset accounts
- Pay down variable rate debts
- Consider whether you can delay significant new undertakings
- Extend the length of your loan
- Can you take advantage of lower prices on shares and property?
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