Last week, the Governor of the Reserve Bank Phillip Lowe gave a speech at the National Press Club. As is the tradition, at the end of his set speech, he was asked questions from the floor. One question stood out among the many.
Daniel Sutton from Channel 10 asked Mr Lowe the following question about what might be about to happen with interest rates: “if it was your mortgage, would you be scrambling for a fixed rate, or would you be sticking with variable?” The question was a lighthearted way of asking a serious question: are home loan interest rates likely to rise?
Mr Lowe took the question in the right spirit, and gave an answer that we really like. He admitted he does not have a mortgage any more himself, having lived in the same house for more than 25 years. He then went on to give some simple, wise advice:
The advice that I would give to people is, to make sure you have buffers… Interest rates will go up. The stronger is the economy, the better progress we make on unemployment, the faster and the sooner the increase in the interest rates will be.
Buffers are a great idea in all areas of personal finance. In this case, Mr Lowe is talking about borrowers using the current low interest period to get ahead on their mortgage repayments. This will mean that, when interest rates inevitably rise, the financial impact will not be as great.
For example, if you or someone you know is paying 2.5% on a variable loan of $500,000 over 30 years, then their interest and principal payment per month would be around $1,975 per month. If the interest rate rises to, say, 3.5%, then the monthly repayment would increase to around $2,245. This is an extra $270 per month.
One simple way for this person to create a buffer would be to make the extra repayments of $270 from today, even before interest rates rise. This gives at least two benefits: firstly, when interest rates rise, day-to-day living need not be affected because the borrower is already paying the higher amount. And secondly, the borrower will actually pay the loan off faster because the extra $270 each month will be paid off the principal.
This second benefit gives you a ‘double whammy’ benefit, because it means that, for every future repayment you make, slightly less of the money paid will pay interest and slightly more will pay off the actual debt. Over time, more of the actual debt is repaid and, eventually, the loan is paid off more quickly.
So, an early repayment makes every future payment slightly better for the borrower.
Buffers can be used in other areas of your finances as well, and in coming weeks we will talk about buffers for people other than borrowers. But before we go for this week, there was one other thing about Mr Lowe’s comments that caught our eye. He was quite definite that interest rates will rise. And he also pointed out that rising interest rates will reflect a stronger economy, especially in terms of unemployment. This is a key point: the current low interest rates are set like that because the economy was not travelling as well as it could have been, even before the pandemic, and obviously the pandemic has caused more difficulties. So, when rates rise to higher levels that will be a sign that the economy is on the improve. Usually, rising interest rates are perceived as a bad thing. But that perception is usually wrong.