Prepare for a rise

As Australia recovers from the global financial crisis (GFC) there’s mostly good news but some bad. On the positive side, more people are employed, investors are gaining from a healthier sharemarket and the strong dollar makes travelling overseas and importing goods much more affordable.

On the flipside, with the risk of inflation, official nterest rates are rising. The Reserve Bank of Australia (RBA) has lifted the official cash rate by 1% since late last year, and if the economy continues to bounce back, NAB’s research team expects the RBA will increase the cash rate by a further 0.75% over 2010 to 4.75% per annum. If you’ve already got a loan, you need to understand the impact that rising interest rates could have on your finances. There are also some things you could do to ease the burden of higher loan repayments.

Know where you stand
“The all-important first step to managing interest rate rises is to complete a household budget”, says Paul Sarkis from MLC. When doing this, you need to work out your total household income and deduct what you currently spend on loan repayments, other essentials items (such as food and utilities) and discretionary expenses. You then need to work out the impact that higher loan repayments will have on your budget. “It’s also a good idea to stress test your finances to see how you’d cope if interest rates increase by a range of increments”, says Paul. “This will give you a clear picture of where you’ll stand in different scenarios and help you decide whether any action is necessary”. If you think your budget will struggle, you should take a close look at your discretionary expenses and see where you could make some cut backs.

Maximise your repayments
If you find you have some room in your budget, you should consider increasing your repayments as soon as possible. This is a smart thing to do, regardless of where we’re at in the interest rate cycle. “Making higher repayments can also enable you to see how your budget would cope if interest rates rise”, says Paul. “Furthermore, by getting ahead on your loan, you may have the option to redraw some of your additional repayments should you need to”.

Offset your loan
Rather than making additional repayments into your home loan, you could ask your employer to pay your salary directly into a 100% offset account linked to your loan. “By doing this, your salary will effectively reduce your loan balance, and the amount of interest you’re charged, from day one in your pay cycle”, says Paul. “This is because the balance of the offset account is deducted from your outstanding loan amount before interest is calculated”. You’ll also have the same access to your money as a regular bank or other transaction account. For example, most offset accounts enable you to access your funds via an ATM, cheque book or the internet. To keep more of your salary in the offset account, you could even pay the majority of your living expenses with a credit card. But you’ll need to make sure you pay off your credit card (in full) before the end of the interest-free period. Otherwise the interest you pay on your credit card could negate the home loan interest savings.

No easy fix
Locking in a fixed interest rate on some or all of your loan will give you more payment certainty.
“For some people this provides peace of mind and may be worth considering if your budget simply won’t cope if rates go higher than the fixed rates available,” says Paul. But when doing this, be aware that if interest rates fall before the end of the fixed term, you could end up locked in at the higher rate. Also high exit penalties could apply if interest rates fall and you want to break the fixed term.

Another problem with fixed rate loans is they lack the flexibility of variable loans. For example, you can’t use an offset account. Also, while some fixed rate loans allow you to make limited additional repayments, they may not allow you to redraw the money. Additionally, when setting the fixed rates, most lenders anticipate future interest rate movements and build this into the rate. ”As a result fixed rate loans are often higher than variable rate loans”, says Paul.

Planning is paramount
As we enter a cycle of rising rates, remember that the better prepared you are, the easier it will be to manage the impact. The more carefully you budget and plan now, the better positioned you’ll be to cope with any interest rate rises that will affect you in the year ahead.

For more advice on coping with rising interest rates speak to your financial adviser.