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How do interest rate changes affect you?

For many Australians, a rise in interest rates will mean increased repayments on mortgages, loans and credit cards. With less disposable income, many people may need to tighten their belts.

Interest rate rises can be tough for families and small businesses, as increased mortgage and debt repayments can make life more difficult and expensive. While lower interest rates can mean a respite in terms of lower debt repayments, or provide an opportunity to get ahead on your mortgage.

When reviewing your finances make sure you look at how interest rates are tracking and if necessary, build in a buffer for further increases that might affect your repayments. It may also be worth looking at consolidating your debts and renegotiating your current interest rates to protect yourself from future increases.

The below summarises some of the economic consequences of interest rate changes.

Increase in interest rates

  • Increases the cost of mortgage interest payments
  • Reduces personal disposable income
  • Increases incentive to save rather than spend
  • Strengthens the value of the Australian dollar
  • Reduces consumption and investment

Decrease in interest rates

  • Makes mortgage interest payments more affordable
  • Increases personal disposable income
  • Encourages spending
  • Weakens the value of the Australian dollar
  • Encourages investment in property

Interest rates rises are generally good news for people with savings. For those looking to invest in term deposits or bonds, an increase in interest rates will generally mean higher rates of return. Term deposits usually offer higher returns in a rising interest rate environment and lower returns in a falling interest rate environment. This is the reason investors may hold a diversified investment portfolio including asset classes, less sensitive to immediate interest rate changes.

With the interest rate rises, you may want to consider reviewing any home or business lending. Talk with us today to discuss how the interest rate changes impact your financial situation.

Chasing yield in a low interest rate world

Low interest rates and unsettled sharemarkets make the chase for yield a challenging prospect. Yield is important, particularly for those approaching or already in the retirement phase as maintaining capital and enjoying a steady income stream are the two key factors to provide for comfort in the years ahead.

But how can you get a decent return when the cash rate is only 1.5% and the interest rate on many traditional fixed interest investments is not much better?

According to Canstar, fixed term deposits are offering an average of 2.69% for one year and 2.87% for five years.i While it is above the inflation rate of 1%, it’s still modest.ii

Of course, there are other conservative investments such as government bonds but even these offer only low returns. According to Bloomberg, 2-year government bonds have a yield of 1.59%, five-year 1.74% and 10-year 2.11%.iii

Corporate bonds

Corporate bonds generally offer better returns than government bonds, term deposits or cash because they carry a higher risk. With corporate bonds, you are lending money to a business in return for interest payments compared with shares where you become a part owner of the company. You can buy the bonds via a prospectus, but these days many are traded on the ASX.

You can currently get yields of around 2.75% for high quality, lower risk corporate bonds, however if you already have exposure to company shares on the market, then adding corporate bonds to your portfolio may reduce your level of diversification.

It is also worth considering investments such as hybrids, which have characteristics of bonds and shares, hence the name. You can currently get a yield of up to 6% in hybrid issues from household name companies including the major banks, ultilities, retailers and insurers.

As an alternative to selecting individual bond issues, a professionally-managed bond fund offers the opportunity to invest in a diversified portfolio of corporate and government bonds and cash.

Good returns from shares

Shares continue to be attractive for investors looking for regular income. The average dividend yield for listed companies is 4.2%; with capital growth, total returns are above 9%. In the latest reporting season some $24 billion was paid out in dividends from Australian listed shares.iv

One key advantage of shares is dividend imputation, where you may actually end up with a cash rebate on the tax that has already been paid by the company.

Stocks such as banks and telcos are often viewed as good sources of yield although concentrating your investments in one or two sectors reduces diversification and increases risk.

Similarly, focusing exclusively on yield may mean that your portfolio is not as diversified as it should be.

Property options

Residential investment property has featured as a major source of investment returns in recent years, but with house prices high and rents tightening the yield has been falling. Add to this the lumpiness of an investment in property – you can’t just sell the kitchen if you need quick cash – and property may carry increasing risk.

Commercial property may be a better option given that in the year to March the average annual return was 14%.v

As an alternative to direct property, listed Real Estate Investment Trusts (REITS) invest in a diversified property portfolio and can be bought and sold on the sharemarket. Since March they have performed quite strongly.v

The hunt for a decent yield in a low interest world is likely to be a feature of investment markets for some time. But your investments, and particularly those that constitute your retirement strategy, should be a long-term plan. Chopping and changing asset classes to try and get a good yield can prove costly.

Call us to discuss the best income-producing investments for your needs.

i www.canstar.com.au/term-deposits/the-current-term-deposit-environment/

ii www.tradingeconomics.com/australia/inflation-cpi

iii www.bloomberg.com/markets/rates-bonds/government-bonds/australia

iv www.commsec.com.au/content/dam/EN/ReportingSeason/August2016/ CommSec_Reporting_Season_August2016_Dividend-windfall-24billion-to-be-paid-out.pdf

v www.afr.com/real-estate/commercial/investment/commercial-property-the-top-investment- in-the-year-to-march-20160517-goxj63

Gearing up for growth

Record low interest rates are making it harder for your money to keep pace with the rate of inflation. While it may be a struggle to grow your wealth in such an environment, low interest rates do mean that it is cheaper to borrow.

So why not take advantage of this opportunity by borrowing money to invest in growth assets such as shares or property? Gearing (borrowing) can be a great way to fast-track wealth creation although it must be remembered that it is a double-edged sword. While using borrowed money magnifies profits, it also magnifies losses. However, by borrowing sensibly and cautiously, and investing in quality assets, the benefits can outweigh the risks.

As well as boosting your returns, there are also tax advantages because you can offset interest paid on your loan against your income.

What are your options?

There are a number of ways you can borrow to invest including home equity loans, margin lending, warrants and internally geared managed funds. Each has its pros and cons so it is wise to get professional advice.

Home equity loans

As the name implies, home equity loans let you borrow against the equity you have built up in your home by using a redraw facility or an additional line of credit.

This method of borrowing is relatively cheap to service as you are only paying mortgage rates of interest. The downside is that you put up your home as collateral.

Margin loans

The second method is via a margin loan where you typically borrow somewhere between 30 to 50% of the value of an asset. The lender will stipulate the maximum you can borrow, called the loan to value ratio (LVR).

If markets fall, your LVR will rise and if it rises above a certain level you have to pay extra money to rebalance your borrowing. This is called a margin call and may be requested at short notice, forcing you to sell some of the investment quickly (and at a bad time) to meet the call.

Warrants add leverage

Warrants, which are traded on the Australian Securities Exchange, give you exposure to an underlying asset for a portion of the price without the need for margin calls.

As a result, a warrant gives you leverage which means small changes in the value of the underlying asset result in larger changes in the value of the warrant. This magnifies gains and losses.

There are many types of warrants, each offering a different level of risk and leverage. Warrants can be on individual shares or on exchange traded funds which offer greater diversification.

The maximum you can lose is the amount you paid for the warrant. As the borrowing is non-recourse, you can walk away and only be liable for the loan.

Gearing made simple

The simplest alternative is to let a professional handle the borrowing for you with an internally-geared managed fund. The advantage here is that you don’t need to take out a loan yourself, risk your home as collateral or face a margin call.

Such funds are for investors seeking capital growth rather than income and should be viewed as a long-term investment as the funds are generally more volatile than the share market in the short term.

You can also gear up your self managed super fund with a limited recourse loan. The rules are complex so it is vital that you receive the right advice to make sure you comply with superannuation laws.

You can turn today’s low interest rates into tomorrow’s gains. If you would like more information or assistance in deciding the best borrowing strategy for your personal situation, such as refinancing your home loan while the interest rates are low, please give us a call on 03 5434 7690.

Homing in on retirement

Pick an Australian, any Australian, and chances are they dream of buying a home or upgrading the one they already own. There’s the emotional satisfaction of knowing you own the roof over your head, the freedom to rip up carpets and keep a pet, and the stability it offers as you raise a family. But home ownership also has a role to play in retirement planning.

For most of us, the long-term goal is to retire with a home fully paid for and enough investments both inside and outside superannuation to support a comfortable lifestyle. What is less well understood is that the better you manage your mortgage and other debts along the way, the more money you will have for income-producing investments to fund your dream retirement.

Spending too much on renovations or buying in the wrong location are common mistakes that may potentially reduce your retirement income. Moving is costly and if a renovation doesn’t add value then it is money that can’t be recouped if you decide to downsize later in life.

The right loan
The loan you choose can also make a big difference to your retirement nest egg. Interest rates may be at historic lows, but there are big difference in the rates available from different lenders so it pays to shop around. If you already have a mortgage, ask your lender for a better deal. More often than not they will reduce your interest rate to keep your business, which saves you the cost of refinancing.

It also pays to think about the type of loan you choose. While interest-only loans often make sense for investors, they can be an expensive choice for owner-occupiers even though on the face of it they appear more affordable.

The catch with this type of loan is that without any repayment of the loan principal, interest-only borrowers are continually paying interest on the full amount of the loan.

The Australian Securities and Investments Commission (ASIC) recently crunched the numbers and found that on a $500,000 loan at 6 per cent, making interest-only payments for just five years can add $37,000 to the long-term cost of the loan.

Once again, that money could be earning compound interest in super and bankroll some memorable travel experiences in retirement.

Tax efficiency
Tax also has a role to play when it comes to managing your housing debt for the best retirement outcome. While your family home is generally exempt from capital gains tax, the favourable tax treatment of the family home does not extend to your home loan.

Unlike investment loans, your mortgage is not tax deductible so paying down the mortgage and freeing up money for investment is an important step in your retirement planning. However, the best place for your surplus cash may depend to some extent on your marginal tax rate.

For people on high marginal tax rates, salary sacrificing into super may be more effective than paying down debt. That’s because pre-tax contributions are generally taxed at just 15 per cent rather than your marginal rate. This strategy is even more effective when investment returns are higher than home loan interest rates.

For people in lower tax brackets it is generally preferable to pay down debt first and reduce interest costs.

Home and hosed
The closer you get to retirement the more important it is to be debt free, especially if your resources are limited.

Unless you rent out a room or enter into a reverse mortgage – a product that has never really taken off in Australia – your home won’t produce any income in retirement. So a balance needs to be struck between the amount of money you sink into your home and the amount you direct into income-producing investments.

If you would like to take a more holistic approach to your retirement planning, including the role of your family home, give us a call.