What to do when property interest rates rise?
Locking down your dream property can be incredibly exciting, but a nagging question might always linger in the back of your mind: what happens if interest rates climb, squeezing your monthly payments?
It’s a legitimate concern, especially considering the recent economic trends. We all know interest rates aren’t set in stone – they fluctuate based on the overall economic health and there’s always a chance they could rise in the future.
The good news is, you’re not alone in this. Many homeowners face similar concerns but there are proactive steps you can take to manage the impact of changing interest rates and keep your homeownership journey on track.
Let’s find out how.
Rising interest rates
Interest rates, those numbers that affect your monthly mortgage payments, haven’t been sitting still lately. Remember the economic slowdown a few years back? Well, central banks like the RBA lowered rates way down to get things moving again.
But the economy’s picking up steam, and inflation (rising prices) is becoming a concern again. So, the RBA, like many others, is starting to raise rates. Here in Australia, we’ve seen a few rate hikes already, and it seems they might continue for a while.
Why this matters to you (the homeowner)
This changing interest rate scene means homeowners need to think about their finances a little differently. Higher rates can make your monthly mortgage payments more expensive which can put a strain on your budget and overall financial well-being.
Thankfully, there are ways to manage this.
Strategies to manage rising interest rates
Refinancing
Interest rates can fluctuate, and sometimes, that means you might be paying more on your mortgage than necessary. Refinancing your mortgage allows you to potentially secure a lower interest rate on your existing loan. This is basically renegotiating a lower rate with a new lender, similar to how we usually look around for better car insurance rates.
For instance, imagine you have a mortgage of $300,000 with an interest rate of 4.5%, and your current monthly repayment is $1,520. If you refinance to a new rate of 3.5%, your new monthly payment could drop to $1,347, saving you $173 per month.
However, there are associated costs with refinancing, such as application fees and potential exit fees if you’re breaking your current mortgage early. These costs need to be weighed against the potential savings from a lower interest rate.
Let’s say these costs total $3,000. You would need to stay in your new mortgage for at least 17 months to break even on your refinancing costs ($3,000 / $173).
Here’s a key point to remember: The longer your loan term remaining, the greater the potential benefit from refinancing. This is because earlier loan payments go more towards interest than principal reduction. So, if you’re early in your mortgage term, refinancing to a lower rate can save you a significant amount of money over time.
Increasing your mortgage repayments
Interest rates are sometimes low. These periods can be a golden opportunity to get ahead on your mortgage and save money in the long run.
By simply increasing your monthly payments when rates are low, you can significantly reduce the total amount you owe.
The extra money you pay each month goes directly towards the principal, not just the interest. This is important because interest is calculated on the remaining loan amount. The lower your principal, the less interest you pay overall!
The advantages of increasing your repayments are twofold:
- Firstly, by putting in a little extra effort, you can potentially shave years off your loan term and you’ll own your home outright sooner and avoid years of additional interest payments.
- The lower your principal balance, the less interest you’ll be charged throughout the life of the loan. Let’s get this with an example:
Let’s say you have a $300,000 mortgage at a 4% interest rate with 25 years remaining. Your regular monthly payment would be around $1,584. Now, if you could increase your payments by just $100 per month, you wouldn’t only pay off your loan 3 years earlier, but you’d also save a significant amount of money – roughly $26,300 in interest!
Reducing other debts
When facing rising interest rates, one effective financial strategy is to reduce your overall debt burden, especially targeting high-interest debts. This involves more than just managing your mortgage; it extends to all forms of debt, such as credit card balances, personal loans, and car loans, which typically carry higher interest rates than home loans.
The rationale here is straightforward: by decreasing these debts, you free up more of your income to manage or offset increases in mortgage payments due to higher rates.
Now suppose you have a credit card debt of $15,000 at an interest rate of 18%. At this rate, if you only make the minimum payment of around 2% of the balance (or $300) each month, it would take you nearly 27 years to pay off the entire debt, and you would pay more than $20,000 in interest alone.
To combat this, if you increase your monthly payment to $500, the total interest drops significantly to approximately $8,000, and the payoff time is reduced to just under 4 years. This not only clears the debt much sooner but also reduces the total amount paid towards interest.
Another approach to reducing high-interest debts is through debt consolidation. This means taking out a single new loan to pay off multiple existing debts, ideally at a lower interest rate.
Imagine you have the following debts:
- Credit card debt of $15,000 at 18% interest.
- Car loan of $10,000 at 10% interest.
- A personal loan of $5,000 at 12% interest.
Combined, you owe $30,000 across various debts with different rates. If you take out a consolidation loan of $30,000 at a lower rate of 8% over 5 years, you could reduce your monthly payments and save on interest. Here’s how:
Without consolidation:
- Credit card: Minimum $300/month could lead to thousands in interest over many years.
- Car loan: $212/month for 5 years, total interest approximately $2,720.
- Personal loan: $113/month for 5 years, total interest approximately $1,780.
- Total monthly payment: $625 and total interest could exceed $25,000 if only minimum payments are made on the credit card.
With consolidation:
- New loan: $608/month for 5 years, total interest around $6,480.
- Total monthly payment: $608, which is simpler and often lower than the combined payments of the individual debts, with significantly less total interest paid.
It’s important to note that for consolidation to be effective, discipline is required to not accumulate new debts and to maintain regular payments on the new loan.
But the thing here is, if you increase your monthly payments, the budget can go haywire anyway. So how will you know if you can sustain these increased payments?
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Conducting a financial stress test
By conducting a stress test, you can identify potential financial pressure points before they become problematic. For instance, if interest rates rise by 2%, a stress test would show how much extra you would need to pay on your mortgage each month, helping you understand whether your budget could handle such an increase. Now, how will you check your capacity?
- Start by taking a close look at your monthly spending. Break it down into essential expenses you can’t avoid, like rent, utilities, and groceries. Then, identify non-essential costs like dining out or entertainment. This exercise helps you identify areas where you could potentially cut back if needed.
- Once you know your expenses, subtract them from your monthly income. This gives you your disposable income – the money left over after covering your basic needs. This disposable income is crucial because it’s the cushion that can help absorb any increase in your mortgage payment.
- Here’s a helpful financial term: your debt-to-income ratio (DTI). It’s simply your total monthly debt payments divided by your gross monthly income. Generally, a DTI above 40% suggests you might have limited room to take on additional debt. So, if your DTI is already high, managing a potential mortgage payment increase could be tougher.
- Consider any upcoming changes in your income or expenses, like a raise, job change, or planned big expenses like education or medical bills. Factoring these in gives you a more complete picture of your financial future.
Utilizing financial tools
Offset accounts and redraw facilities are two powerful tools you can use to manage higher interest costs more effectively:
- Offset Accounts: An offset account is a savings or transaction account linked to your mortgage. The balance in the offset account reduces the principal amount on which interest is calculated. For example, if you have a mortgage of $400,000 and $50,000 in your offset account, you will only be charged interest on $350,000. This can lead to substantial interest savings and lower monthly payments.
- Redraw Facilities: A redraw facility allows you to make extra payments on your mortgage that you can withdraw later if needed. This not only reduces the interest you pay by decreasing your loan balance but also provides a buffer if interest rates rise and you need access to cash. For instance, if you pay an extra $20,000 towards your mortgage and then face a financial emergency, you can redraw that amount to cover your expenses.
Talking to experts
Here at The Investor’s Agency, we understand that these changes can be stressful. That’s why we offer personalized financial guidance to help you make informed decisions and feel confident about your future.
Our team of experts will take the time to understand your unique financial situation and goals. Based on that, we’ll develop a personalized strategy that helps you manage the risks of interest rate fluctuations.
Let us handle the complexities of financial planning, so you can focus on what matters most – your future and your peace of mind.