Why low interest rates aren’t always a boon for consumers
At the beginning of April, the Reserve Bank of Australia (RBA) decided to leave interest rates unchanged at 1.50 per cent.
While the economy is generally on a solid footing, access to credit is tightening, short term bank funding rates are rising, slowing the property market.
Coupled with anaemic household income growth, Australians are putting the brakes on spending. The RBA has declined to increase interest rates, in order to support the Australian economy’s growth.
For many mortgage-holders and other loan consumers, this sustained low interest rate is welcome because it lowers the cost of servicing debt and frees up more cash for other purposes.
Ideally, consumers will spend this cash in the economy, or at least experience a lift in confidence, giving it the boost it needs.
However, interest rates are a double-sided coin and it’s important for consumers to understand both sides of the story.
When consumers borrow money, they clearly benefit from low interest rates.
However, many consumers don’t realise that they’re also lending money to the bank. The money put into savings accounts and term deposits is the money the bank uses to finance home loans, personal loans, and credit cards.
The bank is effectively borrowing that money from consumers. Yet the banks hold all the power in this relationship, with the power to set deposit interest rates at their discretion.
This means that, when interest rates are low on the money consumers borrow from the banks, the banks tend to recoup those losses by offering even lower interest rates on savings and term deposits.
So what consumers gain on the one hand with lower repayment costs, they lose on the other hand with lower returns on their savings.
This relationship is complicated. Most consumers don’t tend to investigate it too deeply. Consequently, there are three prevailing myths regarding interest rates that most consumers seem to believe.
And, believing in these myths means consumers can be caught unawares when rates start to rise, so it’s important to debunk them.
Myth one: low interest rates are unequivocally good for home buyers and the property market
When interest rates are low, other economic markers are often also low, such as wages, income growth, and spending.
That means people trying to save for their first home are disadvantaged by relatively low salary increases that make it hard to put substantial amounts into savings as well as unfavourable saving conditions where the return on investment is minuscule.
When interest rates are low, more buyers can enter the property market, which can lead to overdevelopment and price bubbles.
When these bubbles inevitably burst, people are left with highly-geared assets that aren’t worth what they thought they were and this can hurt consumer confidence.
This was a key contributor to the global financial crisis (GFC), during which unsavoury lending practices led many people to take out loans on properties they couldn’t afford, only to end up owning more than their property was worth with very little prospect of repaying the debt, which was often enormous.
If very low mortgage interest rates are unsustainable, so are some of the debts supporting them.
Low interest rates can also affect some investors who suffer because low interest rates tend to suppress residential property rental income yields once property prices have inflated.
Consequently, investors who purchased at higher interest rates benefit, while non-homeowners and future investors may be disadvantaged in comparison.
More sustainable growth in property valuations is typically driven by wages growth and accumulated savings.
Myth two: low interest rates are good for business
People often think lower interest rates are good for businesses on two fronts: first, the lower rates create more affordable debt, so businesses can access finance more cheaply; and second, consumers have more disposable cash since a smaller proportion of their income is allocated to servicing debt.
That increased disposable income is, theoretically, redirected into businesses, helping boost their income.
However, consumers that rely on interest and fixed income investment returns are disadvantaged by lower rates, as their disposable income is reduced accordingly.
Furthermore, businesses with cash assets will generate a lower return on that investment due to the lower interest rates. And, if the business has little or no debt, then it doesn’t benefit from lower interest rates on loans.
It’s important not to forget that low interest rates usually correspond to inflated property and asset prices (among other factors).
Consequently, expansion efforts in certain industries may be less affordable when rates are low. For instance, commercial property investments have appreciated dramatically.
Rising land taxes can also impact on business and investment cashflow.
Finally, a low rate environment can encourage businesses with more speculative business models, viable only when rates are very low. Thus, unsustainably low interest rates can create fragility and hidden risk within the economy, amplifying the boom-bust business cycle.
Myth three: A low inflation environment is good for pensioners and Australians on a fixed income
While it’s generally true that low inflation means prices on goods and services are not rising quickly, correspondingly, savings and deposit accounts certainly offer retirees lower interest returns.
Consequently, retirees have less money to spend, which can reduce their standard of living. Indexing on government transfers and pensions often lags the actual cost increases on necessary spending such as energy bills and healthcare.
Retirees can be left with more inflation than is generally reported as they have a different basket of goods to those measured by inflation, so the impact of reduced income is felt even more keenly.
Some take on risky investments to boost income, without seeking advice and can end up in a worsened financial position.
With these three myths debunked, it’s clear that there are some instances in which rising interest rates can benefit many consumers.
The key consideration here is how to determine the optimum level of rates for such a diverse economy. It may not be possible to set an ideal interest rate so that everybody benefits, so beware of generalisations.
Regardless, it’s inevitable that rates will increase at some point, particularly if the economy strengthens.
It’s therefore essential for consumers to know how to position themselves to financially capitalise on any change in rates, lower or higher.
This could include: reducing debt or fixing loans; restructuring debt to maximise tax efficiency; diverting cash into other, higher-return investments which are less sensitive to rates; and reviewing investment portfolios to ensure investments will perform optimally in the prevailing interest rate environment.
Financial management is never a set-and-forget exercise. Consumers must be flexible to respond to the changing financial environment.
Evan Tsipas is director at RSM Financial Services Australia.
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