Rising Interest Rates - What You Need to Know

After enjoying unprecedented interest rate reductions for over 11 years in Australia, the music stopped around 4 months ago, just before PM Albanese’s win. A 25 point (0.25%) official cash rate rise from the Reserve Bank was followed by a further 50 points in June, and yet another 0.5% rise in July and August. At the time of writing, the cash rate now sits at 1.85%.

Homeowners and investors who were sitting pretty with record-low borrowing rates are now perking up and starting to panic, as rates incline quicker than Tom Cruise doing 10.3 in an F18 fighter jet. This is all happening despite the RBA’s claim in November 2020 that it would not be increasing the cash rate for at least 3 years until 2024, putting everyone in a false state of ease, fueling record property price growth and lifting confidence. This confidence has now slowed to a crawl as the RBA throttles the cash rate upwards in a manoeuvre some see as 'too big too late’.

How Interest Rates Rises Can Cause Pain for Australians

Rate rises not only affect borrowers, but all consumers of products and services from businesses with debt on their balance sheets or with directors who have rising personal home loan commitments. As interest rates rise, companies will increase their prices to help keep profit where it needs to be, and if they can’t, they’ll have to live with a smaller profit or find another way to cut costs, such as employment.

Monetary policy 101 dictates that if the price of goods increases above the target 2-3% inflation band, then central banks should raise rates to slow the economy. However, on the back of a soul-crushing 2-year pandemic, the pain being experienced by both personal and business loan holders from these sudden moves risks becoming even more excruciating.
A key driver for this heavy dose of rate hikes is the economic data showing a spike of inflation in Australia, similar to what the majority of other developed countries are also experiencing (although thankfully we aren’t as bad as Israel).

This graph shows the downward trend of the RBA’s cash rate target since 1990.

Raising Rates When Inflation Is Rampant

Many business owners are only just getting back up and running after struggling under the weight of lockdowns, rising costs and crippling staff shortages. Now these rate rises stand to impede their hopes of a smooth comeback. The RBA wants to pull the handbrake on the economy, as they try to stem the cost of living through the tightening of spending. One ray of light is our healthy unemployment rate (3.4% in July. The lowest in almost 50 years). There’s plenty of work available for those who want it. To many, increasing interest rates when things are already so tough seems illogical. But it’s a necessary evil to ensure the price of goods and services don’t spiral out of control.

This graph shows the rate of inflation in Australia since 2014, highlighting the recent spike to almost 6%.

Some argue that historically low interest rates are what caused the inflation we’re seeing now; however, as shown in the graph above, inflation has been consistent throughout the period leading up the pandemic, so that argument is easily rebutted. More likely, the flames of inflation have been stoked by the amount of government stimulus during COVID. Policies like JobKeeper saw some companies receive cash payments even though their sales had increased, which only manipulated the system. All this extra cash injected into the economy has had inflationary consequences.

What’s Inside Inflation Figures and What Does It Mean?

Drilling down into the highest inflation reading since the early 2000s - the cost of transport, fuel, food and dwelling prices are the biggest contributors. Supply chain problems have led to increased shipping and freight costs globally. Locally, labour shortages combined with fuel and utility costs have led to higher costs for meat and vegetables. This is likely to continue if nothing is done about it.

Ask a builder or a developer how they’re feeling right now and you’ll understand just how tough inflation is making life in some industries. Builders have seen their standard profits shrink or turn red on the back of fixed-priced contracts that are often unable to be renegotiated. Gradually, this situation will heal as new contracts are entered into, but product delays and price rises have caused substantial stress to the point that many large building firms have fallen over from the lack of cash buffers to protect themselves. Metricon, Australia’s largest home builder, only just escaped a collapse recently by securing a beefed up working credit facility.
The size and importance of Australia’s construction industry cannot be downplayed; it feeds into so many other industries and employs over 1.2 million Australians. Outside the core construction workers are the thousands of developers who often supplement their modest family incomes by completing projects ‘on the side’ and with developments now more risky, there is likely to be a major flow-on effect on spending in the economy, especially discretionary spending.

Some less cashed-up developers and construction companies rely on pre-sales to get their developments moving; however, with the tightening of bank lending parameters, due to the risk of a 15-20% property correction, the ability to start projects is becoming tougher by the day. Consumers are reluctant to buy an off-the-plan apartment if prices are expected to tumble during the construction, and there is an increasing fog around home loan affordability and approval compared to when interest rates were falling. With the cost of physical building materials going up, it’s expected that, similar to car prices, rather than depreciating (as is usually the case), renovations and new buildings will hold their value, while the land prices may drop.

Who Benefits From Rising Interest Rates?

One of the only winners in an increased rate environment, aside from retirees with larger cash deposits, are first home buyers who have been waiting for a correction in the property market. But the expected drop in house prices of 15-20% towards the end of 2023, and the increasing stock available due to financially stressed borrowers selling, is bittersweet. Interest rate rises mean a more substantial starting monthly repayment is required by the first-time borrowers, compared to this time last year.
A good example of this is to look at the fixed rates available this time last year. 12 months ago a home buyer could lock in 2.19% on a 4-year fixed rate, which, at the time was actually a 0.2% discount compared to the then variable rate. Fast forward 12 months and fixed rates are now more expensive than variable rates. Today, the average 4-year fixed principal and interest owner-occupied home loan rate is a whopping 6.00%. That’s 3.81% higher than late 2021.
To put this into perspective, on a $500,000 home loan this is almost $19,000/year in additional interest ($365/week) or $76,000 over the 4-year fixed period! For this reason, there is absolutely no doubt that property prices have to come down, the question is by how much?

What Interest Rate Rises and Inflation Mean For Mortgage Holders

So what’s the best course of action as a borrower? If you haven’t already considered refinancing, there’s no time like the present to see what other rate options might be around. Even negotiating with your existing bank is a great starting point.
It might also be worth re-evaluating your borrowing power. Every bank uses an ‘affordability rate’ to show you can afford your level of borrowing, which is typically 3% above the actual rate you request. As the RBA’s interest rate rises come through, the rate at which the banks assess your borrowing is higher, which directly reduces how much you can borrow from them.
Couple this with the banks’ now heightened scrutiny of debt-to-income (DTI) ratios and you get an even more compelling driver for property prices falling. As borrowers can’t borrow as much, they won’t be able to buy for as much.

Hope on the Horizon for Mortgage Holders

If the economy does officially slide into recession, there’s already some potential green shoots for mortgage holders, as recent inflation data out of the US suggests inflation may have peaked. If the global supply chain woes and energy crises can be brought under control, then inflation in Australia may start to fall into the RBA’s 2-3% target band once again.

This would mean a typical owner-occupied home loan rate won’t surge much higher than 5%, which is where most economists suggest they will be by the end of 2023. There’s so much else at play, however, including the economic fall-out of the ongoing Russian invasion of Ukraine and other geopolitical factors, which could send rates higher.

Where to from here? Have a chat to your bank or a mortgage broker and see how your interest rates stack up compared to what’s currently available. There’s no harm in asking for a good deal!