While I am not a financial adviser and everyone must do their own research when it comes to their personal finances, there is a huge issue unfolding that will hit everyone who has a mortgage – interest rates are set to rise.
At one level, this should be no surprise. The Reserve Bank official cash interest rate is currently 0.1 per cent. It is hard for it to deliver even lower rates.
Which means the only way is up.
With the economy improving and inflation pressures rapidly building, the questions are when, and by how much, interest rates will rise?
Friends and colleagues are talking more and more about housing, mortgages and interest rates. For many with what appear to be huge levels of debt, accumulated as they bid more and more for their house, the prospect of a series of interest rates is disconcerting, to say the least.
Of course the RBA would never hike interest rates to a point that saw these pressures spill over to a hard landing for the economy, but it is increasingly likely higher interest rates will be needed to ensure the economy grows at a pace that is consistent with the RBA’s goal for annual inflation of between 2 and 3 per cent over the medium term.
Start planning now
Forecasting interest rate changes is fraught. There are many moving parts that can derail even the best forecast.
That said, it is no doubt prudent for mortgage holders to have a contingency ‘just in case’ plan that encompasses interest rate rises that may come earlier than currently expected and that are larger than currently expected.
Here is a suggestion for folks who have a mortgage: Log into the mortgage calculator from your bank and plug in a series of mortgage interest rates that are higher than you are currently paying.
And start to prepare for a hit to your household budget, starting in 2022 and probably running for a couple of years.
By way of example, a $500,000 mortgage, with principal and interest over 25 years with an interest rate of 2.0 per cent has monthly repayments of $2,120.
If interest rates are 1 percentage point higher, monthly repayments rise to $2,372 which is $252 extra out of the household budget.
Plug in a 4.0 per cent mortgage rate and the monthly repayment jumps to $2,640 which is a chunky $520 higher than a 2.0 per cent rate.
If we take an even more extreme interest rate risk and assume mortgage rates rise to 6.0 per cent - unlikely but not impossible - the monthly repayments on this $500,000 mortgage rise to $3,222.
Recall it was just a decade ago that mortgage interest rates were above 9 per cent, so never say never.
Past rate-hiking cycles
Since the early 1990s, there have been four interest-rate-hiking cycles from the RBA.
The total of those cycles has been between 1.5 and 3.25 percentage points, with an average rise of around 2.25 percentage points.
Given interest rates are currently so low and were set at this level in reaction to the fallout of a one-in-100-year global pandemic with inflation and wages growth falling to record lows, a return to ‘normal’ monetary policy will likely see an above-average monetary-policy-tightening cycle – something nearer 3 percentage points, or more.
In other words, it is not fanciful to think that over the next two to three years, there will be 3 percentage points of interest rate hikes from the RBA that will flow through to mortgage holders.
Be prepared for such a move. If it does come to pass, your financial prudence now will be well rewarded.
If it turns out that the interest-rate-hiking cycle is less severe, well great! The more extreme elements of your contingency plan will not be needed.