Expert Advice with Simon Buckingham 17/07/2018
Depending on who you bank with, you might have received a letter recently informing you that the interest rate on your home loan has just gone up.
In spite of the Reserve Bank leaving the 'cash rate' on hold again this month (there has been no change in the official rate for two years now), lately a few lenders have begun lifting the interest rates on their home loans and investment loans.
Bank of Queensland, Auswide, Heritage Bank, AMP, IMB, ME Bank, Pepper Group and ING have all recently increased their rates by a fraction of a percent. And it's not only the small lenders, with Macquarie Bank also just announcing a rate rise.
This has led to speculation that other lenders - including the Big 4 (CommBank, NAB, ANZ and Westpac) - might not be far behind... stoking fears of an approaching tidal wave of higher home loan interest rates.
Should We Be Worried?
First up, DON'T PANIC!
The recent increases in interest rates mostly range between 0.05% and 0.15% - unlikely to put much of a dent in the average household budget.
The question is: What comes next?
In order to understand what's going on and whether we should be really concerned, we first need to understand how lenders determine the interest rates they charge customers...
Where does the Reserve Bank fit in, and will they raise interest rates?
Contrary to what some less-informed commentators would have you believe, the Reserve Bank of Australia is not particularly focussed on house prices or property investment. They are neither a friend nor enemy of property investors.
Which is why, despite some in the media suggesting last year that the RBA would increase interest rates to cool the heated property markets of the east coast, the Reserve Bank did no such thing.
Instead, the RBA is tasked with managing inflation.
Why the Economy is like a Bowl of Porridge
Think of the RBA as an economic 'Goldilocks'... they want to ensure that the economy is not running too hot (with inflation out of control), nor too cold (with low economic growth and rising unemployment).
They have the difficult challenge of attempting to find a balance of economic settings - where inflation, economic growth and employment are "just right".
However, the RBA only has limited tools to help them do this - chief of which is the ability to control something called the 'official cash rate' (OCR).
The cash rate is the rate of interest which the RBA charges on overnight loans to banks. This allows the Reserve Bank to influence the interest rates that apply to lending in Australia.
The rate is set by the RBA every month (except January), and any changes to the official cash rate generally affect the rates on home loans and forms of credit within a matter of days or weeks.
What the cash rate ain't...
The cash rate is not an instruction to lenders about how much interest they can charge customers on home loans or other credit.
There is no legal obligation on banks in Australia to raise or lower their interest rates in line with changes to the cash rate. This is why many lenders don't pass on the full amount of any reduction in the cash rate, and may even put up their rates independently of any change to the cash rate.
Of course, history tells us that when the cash rate does go up, banks in Australia are pretty quick to increase their own interest rates by at least the same amount.
What the cash rate is...
The RBA defines the cash rate simply as "the interest rate on overnight loans in the money market".
In other words, it is the rate of interest a bank must pay to the Reserve Bank if it takes out an overnight loan. For example, if the NAB borrows $100,000 from the Reserve Bank overnight, and the cash rate is currently 1.5%, then the bank would have to pay the RBA an $1,500 per annum for the privilege (or $4.11 per day).
Banks borrow overnight in this fashion because the daily volume of their transactions is unpredictable, so they can often run out of the liquid cash required to complete those transactions. This means the banks often have to borrow from each other, or from the RBA, in order to meet their obligations.
When the cash rate is low (like it is right now) borrowing overnight from the RBA is a cheap and easy way for the banks to handle any shortfall in cash on a given day. This makes the banks a little more willing to take risks, meaning they're likely to lend more to consumers and businesses - which helps stimulate economic activity (like consumer spending, business investment, employment etc.)
Changes to the cash rate therefore have an indirect impact on what we actually pay in interest on our loans and credit cards.
But just because a bank has access to cheap overnight funds from the RBA, this doesn't necessarily mean it will keep interest rates low on its loan products.
This is where the court of public opinion comes in...
When the public sees the RBA cut the cash rate, there's an expectation in the community that mortgage interest rates should also fall. A lender that does not cut its rates when the cash rate falls is going to be unpopular and potentially lose business.
Hence, most lenders cut their rates to some degree when the RBA cuts the cash rate (even if they don't reduce their rates by the same amount).
And in the absence of the RBA increasing the cash rate, public opinion keeps the pressure on the banks to maintain and not increase their current interest rates.
But - by similar logic - any increase in the RBA's cash rate becomes a convenient excuse for the banks to increase their own interest rates without much public or political fallout.
If the cash rate is on hold, why are some lenders increasing their rates?
This comes down to how the lender actually sources the money that it lends to you.
Lenders can raise the funds they use for lending in essentially 4 ways:
1. Domestic deposits (i.e. customers' savings and deposit accounts)
2. Domestic 'wholesale' funding (i.e. borrowing from other Australian lenders)
3. Offshore 'wholesale' funding (i.e. borrowing from international money markets)
4. Shareholders' equity (i.e. raising capital by issueing shares)
Since the GFC, Australian banks have significantly increased the proportion of funding they source from deposits, rather than wholesale funding or other sources.
Around 65% of the funding used for lending by Australia's big banks now comes from domestic deposits. Approximately 17% comes from offshore wholesale funding, 10% from domestic wholesale funding, and most of the rest from shareholders' equity.
Because they get so much of their funding from deposits, many Australian banks are somewhat insulated (although not entirely immune) from the impact of rising interest rates on international money markets.
However, some smaller banks, non-bank lenders, and foreign-owned banks may source a greater proportion of their funds from wholesale money markets, and are therefore impacted more when interest rates start rising overseas.
International money markets are heavily influenced by what happens to US interest rates. With falling unemployment and a strengthening US economy, the US Federal Reserve has recently begun increasing interest rates in the USA.
Adding to this are tensions over the risk of a trade war between the US and China, and ongoing financial issues in the European Union. These concerns affect the "risk appetite" of global money markets, which can make wholesale funds harder to come by and push up the cost of those funds.
Therefore, lenders who source a significant proportion of their funds from wholesale money markets are more vulnerable to rising offshore funding costs, and can only absorb rising costs for so long before they have to pass on some of the cost to their customers in the form of higher interest rates.
One Benefit of the Banking Royal Commission...
The spotlight of the banking Royal Commission is also still on the Big 4 banks, so they're super sensitive to anything that might further damage their image. The pressure's therefore on them to keep interest rates stable in the absence of the "excuse" of a cash rate increase from the RBA.
Furthermore, the Royal Commission has caused many customers of the big banks to re-think their loyalty to their bank. A rate rise by any one of the Big 4 might just encourage more customers to defect to other lenders - something the bank's shareholders are unlikely to be happy about.
For this reason the Big 4 banks are likely to be the last to raise rates, and may try to minimise any increase if they can't hold rates where they are.
We may even see some lenders reduce rates for certain loan products in order to try to retain or capture market share.
But smaller lenders and non-bank lenders who don't have the same access to funds from deposit accounts, won't have the same ability to offset rising funding costs.
So we are seeing (and will continue to see) a number of lenders attempt to pass through some of their increased funding costs in the form of higher interest rates on loans.
No Interest Rate Tsunami
Don't expect a tidal wave of rapid or substantial rate rises this year.
We're more likely to see small, incremental increases among some but not necessarily all lenders.
In the absence of strongly rising wages or an inflationary shock, the Reserve Bank will likely leave the 'cash rate' more or less where it is.
But with offshore funding pressures building, we'll probably see the actual interest rates charged by lenders move up gradually over the next year.
Keep in mind that interest rates remain at historically low levels in spite of these small increases, and there are still plenty of highly competitive rates around.
What to do about it all...
If you've just had a rate rise, then make sure you shop around to see if you can qualify for a better deal.
And if you can see better deals out there, don't be afraid of attempting to negotiate with your existing lender. Point out the better deal to them, and ask if they are prepared to provide a discount on your current interest rate.
It doesn't hurt to ask! - You should be doing this on a routine basis anyway.
Note that switching between lenders isn't necessarily as easy at the moment as it used to be, because of the more stringent tests on your loan servicing ability and differences in how lenders will assess existing debts and your living expenses. But it can still be worth shopping around.
More importantly, as a prudent sophisticated investor, you should always test your portfolio to see how it would be impacted if interest rates rose by 2%.
This is doubly important when crunching the numbers on any new property deal that you're planning to take on.
Rates might not increase very quickly over the next year or so, but if a 2% increase in interest rates would make the difference between the deal working or not, or of you being able to afford the property - then perhaps it's not a good deal to begin with.
Make sure you'd still be happy with the property deal even if interest rates rose 2% over the life of the deal.
If you’d like to learn practical techniques that can help you evaluating property deals for potential profitability before buying, plus strategies for adapting to changing market conditions and unlocking finance today, then come along to one of our upcoming free in-depth property investing workshops.
Don't be alarmed by the recent small movement in some lenders' interest rates.
Just be alert. Plan ahead, and be sensible when running the numbers on your next property deal.
In other words... Invest Wisely!
Simon Buckingham is Director of Results Mentoring and a highly experienced investor. Simon has been investing in property for over 15 years using a broad range of strategies including positive cash flow, renovations, property development and commercial properties, both within Australia and overseas.
Holding university degrees in Commerce and Law, and with over 10 years' experience as a business consultant, Simon turned his back on corporate life forever following the births of his two children and now spends his time investing, developing property, supporting multiple charities, and building businesses - while teaching others how they can do the same. He has personally coached hundreds of investors in techniques that can be used to profit from property in any market conditions, regularly facilitates public workshops and provides other free resources for property investors through ResultsMentoring.com, and has presented to thousands of people at property conferences and seminars around Australia and New Zealand.
Simon writes the highly regarded Sophisticated Property Investor e-newsletter and his opinions on the property market and real-world investing strategies have featured in Your Investment Property magazine, Smart Property Investment, Channel7 News at 6, Kevin Turner's Real Estate Talk, and Property Observer. He is co-author of the critically acclaimed property book The Real Deal: Property Invest Your Way to Financial Freedom, and a founding Mentor in Australia's award-winning personal mentoring service for property investors: the RESULTS Mentoring Program.
Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.