The danger of low interest rates

With record low interest rates, it may be tempting to borrow more money to buy your dream home while the repayments are also low.

Australia’s cash rate has been on hold at 2.5 percent for the past nine months and while the rates charged by lenders on mortgages are higher than that, servicing a mortgage is nevertheless much more affordable than when interest rates reached an all-time high of 17.5 percent in January 1990.

However, low interest rates will not last forever. Financial experts are already predicting that the Reserve Bank of Australia will begin raising the cash rate later this year or early next year.

“The current talk is that we will see likely rises in 2015,” said Paul Cooke, senior adviser with Parker Financial Services.

New Zealand has already raised interest rates twice this year to 3 percent, with further hikes expected in May and June.

Likely rate rises or not, Cooke cautions against falling into the trap of overextending yourself and borrowing too much while interest rates are low.

“When home buyers are doing their borrowing and assessing their ability to service loans, they should pick a buffer,” he said.

Cooke’s advice is to always calculate your ability to meet your repayments at two percentage points higher than the rate you secure for your home loan.

“For the past couple of years I’ve been using 7 percent or 7.5 percent,” he said.

“If you can’t afford the repayments at the higher rate, it’s too risky.

“Always pick 2 percent above where we are and if you can’t re-service the loan at that rate, you’ll potentially be in trouble in the future.”

While it may take two years for interest rates to rise by two percentage points, Cooke argues that a rise off a low base has a greater impact on the hip pocket than increases when interest rates are at a higher level.

“If interest rates of 6 percent go up 2 percent to 8 percent, you have a 30 percent increase in what you have to pay. If they are at 8 percent and go up to 10 percent, it’s a 15 percent increase in your repayments. So in a low interest rate environment, if rates go up they have a higher impact – it’s a huge difference in absolute dollars.”

Caution and doing your homework to find the best home loan for your needs will stand you in good stead once interest rates begin to rise again.

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