The interest rate is the cost of credit.
Interest is the cost of credit.
There is no single interest rate.
Rates vary according to the availability of funds and the risk attached to lending for a particular purpose. There is a direct correlation between risk and the premium charged. As risk rises, so does the price of credit.
The investment loan mortgage rate is the one that is of consequence 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 responsibility to help manage inflation and unemployment. Interest rates are ‘tightened’ (upward pressure applied) to control inflationary spending, and eased to stimulate growth and employment.
Interest rate rises for the investor are not as ominous as the media would often have you believe. When rates increase, fewer 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 significantly reduced by the fact that part of every dollar in interest you pay may be returned to you by the ATO at your marginal rate.
“In addition to enterprise-wide stress tests, portfolio-level and risk-specific stress tests of residential mortgage lending portfolios are considered good practice.” Prudential Practice Guide: APG 223 Residential Mortgage Lending APRA 2019
Central to that stress testing obligation is lenders applying a ‘qualifying rate’. They work out if you can afford to borrow even if rates rise by around 2%. 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 genuinely creditworthy! The idea is that even if rates rise, you can service the 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 if a conservative valuation falls short of the package price, forcing you to contribute more or to withdraw from the purchase, the ‘comparison rate’ is a price too high to pay.
It can be their informal way of securing themselves. Insisting on saving .25% on a $300,000 loan over 10 years = $7,500. But, if that lender’s criteria are so strict and they won’t allow the deal to ‘work’, as an investor you may potentially forgo capital gain for ten years, traditionally 7.2%pa or in this case $300,000 profit! Remember opportunity cost. The biggest cost is doing nothing at all.
A variable interest rate fluctuates in line with the Reserve Bank’s Monetary Policy and more recently, the retail banking sector’s discretion!
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. Keep in mind, though, if the bank’s fixed rates are falling, they are expecting them to go even lower in the future.
Even though the official cash rate may be as low as 0.1%, the price 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 2.1-3.0% while the cash rate is as low as 0.1%.
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. In recent times the banks have been accused of ‘hijacking monetary policy’ by either not passing on the rate cuts 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.
At a micro or household level, credit allows us to create wealth by purchasing assets that appreciate over time. It also allows us to buy 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 liability 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 repayers. 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 more significant 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 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 reasonably 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 the 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.