The Impact of Rising Interest Rates
Story by Nathanial Campbell
As has been widely reported, inflation in Australia is at its highest level in decades. This has led the Reserve Bank of Australia (RBA) to increase the official cash rate from 0.10% to 2.60% in the space of six months. This is the fastest increase in the cash rate since 1994 when the RBA increased rates by 2.75% in the space of five months.
In addition to these recent hikes, the reality is that in all likelihood, we still have further to go. All the major banks are forecasting further increases totaling between 0.50% and 1%. They are expecting to see these rate rises occur between now and April next year, at which point the cash rate is expected to peak. The top end of this range would see the cash rate reaching 3.6%. To give this a bit of context, the long-term average cash rate over the last 32 years is 4.45%. Therefore it is fair to say that, whilst the speed of the increases is unique, the actual cash rate is returning to a somewhat “normal” level.
What is important to most Australians however, is not the reasoning behind the rate rises, but the impact that rising rates will have on them.
The first, and most obvious impact, is the increased loan repayments due to the higher rates, resulting in less disposable income. The RBA hope that this reduction in disposable income will result in households spending less. However, during covid Australians did an amazing job and managed to save more than ever before. On average, home loans were over 22 months in advance as a result of these savings. This means that even with the increases in interest rates it would be many years before the repayments on these loans would need to increase. Instead, it will just gradually erode the payments made in advance, therefore not reducing the disposable income of the homeowner. The people that suffer the most from the increase in repayments are those that have purchased a home over the last two years and haven’t had the opportunity to buffer against the increasing repayments by paying extra off their home loan. It is these people that are experiencing a drop in their disposable income and are needing to reign in their spending.
Increasing interest rates can be bad news for people looking to take out a loan to purchase a property, especially people just setting out on their journey in the property market. In the last six months the borrowing capacity of a first home buyer with an income of $80k has reduced from around $500k to $380k. That is a 20% drop in six months which is quite staggering. Whilst the property market has cooled, it definitely hasn’t dropped 20% in six months. The speed of these rate rises has meant that people who may have held pre-approval just a month or two ago are now in a position where they could potentially no longer purchase a home.
In short, borrowing capacity comes down to two things, income and expenses. If you are looking to increase your borrowing capacity the key is to control what you can. Personal loans and credit cards hurt, whereby a $10k credit card will reduce your borrowing capacity by around $60k. The same applies with personal loans – avoiding these facilities where possible will assist greatly when being assessed for a loan. Then managing our budget and trying to reduce unnecessary expenses comes next, to allow you to show that you can afford the repayments associated with a new loan.
The flow on effect from reduced borrowing capacity is that there are less buyers in the market, and the property market has slowed accordingly. We have seen a shift from a sellers’ market to a market that favours purchasers. For those that have equity in their current property and capacity to borrow, opportunities to purchase quality investment properties may present themselves over the coming period as those that are not comfortable with the increasing rates look to sell.
It is this slowing of the property market that may help take the pressure off inflation more than the reduction in disposable income. Confidence in the overall economy is a huge driver in people’s willingness to spend. As property prices ease people tend to feel that their personal wealth has reduced, in turn driving down confidence. As mentioned earlier, the increase in repayments will only impact a small percentage of the population, but the lower confidence levels will be far more widespread.
The good news is, historically, when the RBA goes through a cycle of increasing interest rates they usually overreact and move rates a little too far. They then need to reduce rates a few months later. This is because the data that they rely on when making decisions on the cash rate lags the actual changes. As the rates increase and spending slows, inflation falls, but this data may not be available for a few months. A number of economists are now forecasting that we may see a rate cut or two in the back half of next year.
The idea of increasing interest rates is to slow the economy, and all in all, it generally works. The cycle of increasing rates usually takes between 6-12 months before the RBA gets to a point that they are comfortable with, or even to a point where they may need to reduce rates slightly.
Interest rates are coming off all-time lows, so the speed of the increases is unique, but we are still well placed, with rates lower than the long-term average. With a bit of luck, we will get through the next 6 months and rates will have settled down, we may even be talking about when the next rate cut might occur. There is no denying that people are feeling the pinch with interest rates increasing, unfortunately this is the whole idea, and what the RBA is after, a bit of short-term pain, so that the cost of living doesn’t continue to increase at a rapid rate.
Nathanial Campbell is a credit representative (507504) of BLSSA Pty Ltd ACN 117 651 760 (Australian Credit License 391237)