Interest Rates — To Fix or Not to Fix?

Interest rates are a topical issue. Whilst their future direction is almost impossible to predict it is valuable to consider the mechanics of how they work and what affect they may have on cash flow.

We are currently in an environment of relatively low interest rates when compared to long term historical trends. Similarly the economy, employment levels, inflation, and many other economic indicators are at historically favourable levels.

With this in mind, the Reserve Bank of Australia (RBA) will use “monetary policy” as an instrument to attempt to maintain these favourable economic conditions mentioned above by using interest rates to get the desired outcome.

In general the RBA will implement monetary policy by increasing the official cash rate when they believe the economy is “over-heating”, or similarly will lower this cash rate in order to stimulate a weaker or “lagging” economy. Financial institutions generally will then pass on these changes to the borrower via correspondingly higher or lower interest rates.

During periods of rising interest rates borrowers who have “variable rate” loan facilities will have a greater burden placed upon them and will be required to service any interest rate increases solely from their cash flow. The negative impact on household cash flow can be significant especially when exposed to a high level of debt. The great worry is that interest rates will rise and households will be forced to service more and more interest repayments from their fixed household budget. In an explosive or ‘runaway’ interest rate environment most people may find themselves unable to manage their cash flow because of this interest rate burden. Historically, this scenario has played out before in the period 1989 through 1991 and many borrowers suffered significantly and in some instances were bankrupted because of rising interest rates. Many people remember rates of 18% from approx.25 years ago and the pain associated with those high levels of interest rates.

Although movements in interest rates are almost impossible to predict there are strategies which can be employed to mitigate the impact of an interest rate rise on cash flow.

One risk mitigation strategy might be to fix some or all of the interest rates applicable to a home loan or other debt .By doing this a borrower has greater certainty with regard to their outgoings for the period of time that those rates are fixed.

As a counterbalance to this strategy it is important to understand that alternatively clients who have a variable rate whilst interest rates are decreasing will participate in the benefit of these falling rates and save money. As well, when interest rates continue to fall the major disadvantage for the borrower in fixing interest rates will be that they are locked into a higher rate of interest and therefore will pay more interest than would otherwise be the case. As well, should a borrower wish to break the fixed rate agreement there are generally significant penalties to do so by way of ‘break costs’.

For 20 plus years we have seen a long term downward trend in standard interest rates in Australia from the high teens near 18% to the current lows near 4.5 to 5.0%. Eventually interest rates will go back up again but determining when that will happen is almost impossible. As a general rule fixing interest rates as a strategy should be engaged as a means to create “peace of mind” regarding a person’s cash flow, and not necessarily as a means to “beat” the market or the Reserve Bank. The best approach is to work out an interest rate strategy with regard to debt and cash flow which creates diversification and enhances risk management.

The intangible benefit of creating an element of clarity[certainty] in the cash flow of a household cannot be overstated.

To ensure your interest rate risk is managed effectively, talk with us at Paladin and have us make an assessment of your situation.