Interest rates are the cost of credit. There is no one interest rate. Rates vary according to the availability of funds and the risk attached to lending for a particular purpose. The home loan mortgage rate is the one that is of significance to investors and is relatively low because the asset securing the loan is a physical, ‘bricks and mortar’ asset.
Interest rates are cyclical, they go up and they go down in line with the Reserve Bank’s duty to help manage inflation and unemployment. They are ‘tightened’ (upward pressure applied) to control inflationary spending and they are eased to stimulate growth and employment.
- Interest rate rises for the investor are not as bad as the media would have you believe. When rates increase less people buy their own homes and more enter the rental market, putting upward pressure on rents. Higher rates mean more tax deductions. The net effect on the bottom line for an investor of a .25% increase or even a whole 1% increase is greatly reduced by the fact that part (32.5%, 37% or 45% + 2% for Medicare) of every dollar in interest you pay is rebated back to you by the ATO.
- Don’t forget too that lenders have a ‘qualifying rate’. They work out if you can afford to borrow even if rates rise by 2-3%. They don’t approve loans that are servicing on the current interest rate; they factor in the expectation that rates are cyclical. If you get approval, you are truly credit worthy! So, even if rates rise you have the capacity to service debt without undue pressure.
- When considering finance options the best lender is the one who will do the deal for you! Some promise low rates but bring in valuations short of the package price, forcing you to contribute more. It’s their unofficial way of securing themselves. Insisting on saving .25% on a $300,000 loan over 10 years = $7,500. But, if that lender’s valuations is low and won’t allow the deal to ‘work’, as an investor you may potentially forgo capital gain for 10 years, traditionally 7.2%pa or in this case $300,000 profit!
- A variable interest rate fluctuates in line with the Reserve Bank’s Monetary Policy and more recently, the bank’s discretion! For property investors a variable rate loan is usually the most appropriate.
- A fixed rate is set for a specific term of the loan. If borrowers can pick the bottom of the market, this can be a beneficial strategy.
Even though the official cash rate may be as low as 1.5-2%, the rates charged by lenders is higher because they add a margin on top – this is how they make a profit. So, housing mortgage rates may be 4-5% while the cash rate is as low as 2%.
Monetary Policy is RBA action to influence the availability and cost of credit by adjusting the cash rate. To be effective, banks need to pass on the reductions in rates to their customers but in recent times the banks have ‘hijacked monetary policy’ by either not passing on the rate cuts determined by the RBA or by increasing their rates outside the policy cycle. This why the Governor of the Reserve Bank has suggested that customers compare lenders and products, not be complacent and ‘shop around’! Competition is a powerful motivator for lenders to keep and win new business.
How does this relate to investment decisions?
At a micro or household level, credit allows us to create wealth by purchasing assets that appreciate over time. It also allows us to purchase assets that depreciate over time but enhance our standard of living, the cost we incur is the interest we pay. For most people the single largest purchase in their lives will be the family home and so it’s not surprising that the lion’s share of private sector debt is for housing and the rest is predominately credit card and vehicle debt. Housing debt includes owner occupier debt and to a lesser degree housing investment debt. Credit card debt is considered ‘consumption debt’ because we buy things with credit cards that get used up quickly or fall in value over time, typically it’s classified as ‘bad’ or unproductive debt.
As a nation we are by and large committed and reliable re payers. Housing loans in default hover around the less than one percent mark and a significant proportion of borrowers are ahead in their payments. It seems a lot of us are not necessarily ‘great savers’ but we are ‘great payers’.
So how does all of this relate to an investment property purchase decision? Given that our lenders, with strict prudential supervision, are comfortable lending up to 100% of an investment property purchase is a strong endorsement of the safety in bricks and mortar as an investment. Borrowing to invest allows you to access the power of leverage and purchase assets much larger than you would be able to if you had to fund it using your own money. The cost will be the interest you repay to the lender but that cost like all associated with owning an income producing (rent) asset is tax deductible. The cost of borrowing is weighed up against the opportunity cost of not investing now.
Time in the market is important when investing in property so any recommendations need to be based on the idea of ‘sustainable investment’, can you afford to hold the property for the long term, allowing for fairly predictable changes in circumstances over time and movements in interest rates? Why? Because interest rates will change over time as sure as night turns into day.
Monetary Policy is Reserve Bank action designed to influence both the availability and cost of finance in the economy. Interest rates are pushed up to slow the economy and limit inflation and they are eased to encourage spending and activity and therefore employment. So, as economic circumstances change so will the prevailing cost of credit. When calculating out of pocket costs for an investment purchase build in a buffer, ask to see the figures at an interest rate of 1-2% higher than currently on offer. Keep in mind though that given the RBA typically adjusts the dial by .25% at a time you have many adjustments before you reach the 2% mark.
The upside of a rate increase is that your tax deductions increase and more people may delay buying their own home and continue to rent and put upward pressure on rents.
Remember, ‘profit is the return to risk’ so you do have to take some risks if you are to build wealth for the future but make it a calculated risk.