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15 Jul 2022

How to budget for interest rate rises

By Anthony Si, Senior Investment Specialist for Citi Branded Wealth As interest rates rise keeping an eye on the family budget has increased in importance. The environment, particularly where inflation is heading remains uncertain, but although there are risks on the horizon there are also silver linings.

This month the Reserve Bank of Australia (RBA) followed up June's 0.50 per cent interest rate hike with a further rise of 0.50 per cent, taking the official interest rate to 1.35 per cent. Markets are pricing in further rises and it indicates rates will hit 3.1 per cent by year end.

While many lament the end of the historic lows interest rates hit during the pandemic, we need to keep it perspective. In the 1990's and 2000's the average cash rate was about five per cent, and it was only in 2016 that the rate dipped into the RBA's preferred range of between 2-3 per cent.

In the United States, analysts had already talking of peak inflation in the past tense, with expectations mounting that inflation would drop to 6.5 per cent by year end and 3.5 per cent by end 2023. However, the US June inflation number of 9.1 per cent came in higher than expected, and has fuelled expectations of more large hikes in US interest rates.

The US Federal Reserve has made it clear it is willing to inflict substantial pain on the US economy to curb inflation, and favoured recession over stagflation - the latter is where interest rates and unemployment are rising and economic growth is anemic.

While Australia is not expected to reach the inflation highs being experienced in the US, it is still rising and the RBA is expected to raise rates a number of times before year end.

We are in a changed environment with additional pressures on potential home buyers and a more focused mindset on costs and help available is required.

Use online tools to assess the precise impact of changes

As with any situation of uncertainty, it’s important to accurately assess the potential impacts of changing conditions, in order to best make plans to deal with them in advance.

We have personal loan calculators to allow buyers to determine loan repayments, borrowing power, and compare loans. You can access them here.

In order to determine the impact of interest rate hikes, these online tools can estimate what repayment levels will be in the case of varying increases.

This information can be used as a sound basis for future budget planning and financial decision-making.

How will interest rate hikes affect mortgage costs?

Using online calculators, it’s easy to determine that a rise in the target interest rate may lead to significant changes in monthly mortgage repayments, and increases based on the principal of the loan.

Mortgage holders with a 30-year $500,000 mortgage could have seen their monthly repayments increase by $350 a month if the June 0.50 per cent rate hike by the RBA was passed on in full by their loan provider. Mortgage brokers are well placed to discuss how this may impact buyers.

Making higher repayments prepares buyers for rate hikes

Making repayments that are higher than required can be an excellent means of preparing in advance for potential rate hikes.

By making repayments at rates that are two to three percentage points higher per annum than the initial interest rate, buyers will become accustomed to a financial planning routine that will provide a safety buffer against any real rise in repayments requirements.

In addition to granting a safety buffer, it also helps reduce the life of the loan.

Keep an eye on other contingencies

In addition to potential interest rate hikes, it’s also important to keep in mind other potential contingencies which could affect home owners buyers ability to service a mortgage, both for better and worse. This could include shifting job and income conditions, that could lead to either more or less funds available for making loan repayments, as well as sudden health emergencies, or changes in rental conditions when it comes to investment properties.

If buyers plan well and take the advice of experts they can ensure that they are well prepared for any sudden shifts in repayment requirements.

 

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Any advice is general advice only. It was prepared without taking into account your objectives, financial situation, or needs. You should also obtain and consider the relevant Product Disclosure Statement and terms and conditions before you make a decision about any financial product. Investors are advised to obtain independent legal, financial, and taxation advice prior to investing. Past performance is not an indicator of future performance.

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