On 7 June, the Reserve Bank of Australia (RBA) increased interest rates with a mammoth 50-basis-point hike taking the cash rate target to 0.85% - well ahead of most economists’ expectations.
This follows May’s historic rate hike, which saw the cash rate shift from emergency lows to 0.35% - the first raise in 11 years. Forecasts are that the cash rate could even hit 2.5% by the end of the year, as the RBA takes further steps to curb inflation and monetary conditions in Australia.
But what does this mean for you and your family? Claire Charlton, Lending Specialist Manager, addresses your questions about high inflation, interest rate rises and how this will affect your mortgage repayments.
1. I’ve been hearing a lot about high inflation in the market, what does this mean?
For the last few decades, inflation has not been much of an issue. However, since around May last year, following a surge in inflation in many countries and most notably in the US, it’s certainly become more of a talking point.
Inflation refers to the generalised and persistent rise in the price of goods and services that households buy. It is measured as the rate of change of those prices. Typically, prices rise over time, but prices can also fall (a situation called deflation).
The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.
As you will know from your trips to the supermarket and filling up your cars in recent months, prices have been rising. In fact, after many years of low inflation, inflation is now at levels not seen for quite some time.
In the US, for example, inflation at the end of April was 8.3%, the highest level since the early 1980s. Inflation in the UK, and the 27 European Union countries is also higher than it has been for decades.
While Australia’s inflation rate at the end of March was 5.1%, a figure lower than in many other countries, it was still the highest level since the Goods and Services Tax (GST) came into operation in July 2000.
High inflation is bad for consumers and households as it means that prices are rising quickly, usually faster than wages. Inflation is, in effect, a tax on people’s living standards and spending power. You only have to think of the hit to your wallets from high petrol prices and rising supermarket bills.
At the same time, inflation effects businesses and companies, including companies listed on share markets, in different ways. Some companies and businesses can pass on higher costs to their customers, which may be good for the company, but bad for their customers. Historically, health insurance companies have greater pricing power and pass on rising health care costs to their customers through higher premiums. And as we all know from our trips to the supermarket, companies in the food and beverage industry also tend to pass along higher costs to consumers.
Then there are companies and businesses that don’t have the ability to pass on higher costs and just have to accept them. By having to accept higher costs, profits suffer. For companies like McDonald and Yum! Brands – which owns KFC - inflation is showing up in costs of labour, packaging, beef and other inputs. Companies like these generally will take smaller, more frequent price increases than less frequent large price increases to offset inflation. However, prices are set by franchisees, and are tailored to the local market.
Cost increases also hit technology companies, especially when large order backlogs and subscription models delay the effects of price increases.
All up, high inflation tends to be bad for most businesses and economies, and this is reflected in recent investment market movements, where major share markets, as well as bond markets, have weakened.
2. Why is rising inflation linked to a rise in interest rates?
Broadly speaking, central banks, like the RBA, raise and lower interest rates to stimulate economic growth and control inflation. If inflation is high, they might raise rates to try to control it. If it’s low, they may lower rates to encourage consumers to spend and borrow money.
Borrowing, whether to invest, to buy a home, renovate or buy a car, is an important part of economic activity. As such, the RBA recently increased interest rates, that is, increased the cost of borrowing, to try and slow down the pace of economic activity.
This is because raising interest rates makes borrowing money more expensive. And when borrowing becomes expensive, it can mean less demand for goods and services – like a house, or car.
Generally, as the pace of economic activity slows, inflation also slows. Major central banks have made it clear that they intend to increase official interest rates to levels that will bring recent inflation under control. However, there is uncertainty over how high interest rates may need to rise to bring the current inflation under control. It’s this uncertainty that’s also been causing recent investment market volatility.
3. How do interest rate changes affect my mortgage repayments?
The interest rate affects the total amount you’ll repay over the life of your home loan. Generally, any fluctuation in the interest rate changes the total amount your home loan will cost you.
In the case of Principal and Interest mortgages, repayments are made up of two components. The first part is a portion of the principal, and the other is the interest charged on that principal amount. To work out your monthly repayments, your lender will divide the total amount you’ll pay over the life of your loan by the number of months in your loan term. You’ll end up paying almost an equal amount each month.
If you have a variable rate home loan, then you will see an increase in the amount you need to repay almost immediately. On the other hand, if you have a fixed rate home loan, you won’t see an increase until the fixed-rate period expires.
If the recent increase is passed on in full by financial institutions, someone with a typical $500,000 principal and interest loan over a 30-year period could expect to pay an extra $137 a month in repayments. These are just approximate figures, and any increase in your repayments will depend on how much your lender raises its interest rates, or the type of loan you have in place.
A home loan calculator is a very convenient way to see how the interest rate changes affect your mortgage repayments.
4. Should I get a fixed or variable home loan in the current market?
For many of us, a home loan is the biggest financial commitment we’ll ever make. Choosing the right option in the current market can feel daunting. It’s important that you consider your own needs and circumstances when deciding on the right rate mix.
A fixed mortgage provides you with the stability of a set interest rate to give you certainty in the amounts of repayments whilst on the fixed term. However, making the switch at the wrong time can lock you into a higher-interest loan. It also means that it may be more difficult to take advantage of any lower rates the future may bring through the fixed term.
Variable rates can be lower than fixed rates at times but may fluctuate over the life of the loan – as we are seeing now. An increase in mortgage interest levels means that those with a variable loan must meet the requirement of the rising rates. This unpredictable nature might warrant some concern, especially if rates keep going up.
With a variable loan, you can make extra repayments if you wish to do so, whereas a fixed home loans often have restrictions. Making extra repayments on your mortgage can cut your loan by years. Directing additional repayments from any surplus income you may have – this could be your tax refund or bonus for example - towards your mortgage could save you thousands in interest.
Split loans are also available, which allow you to fix a portion of your mortgage at a set interest percentage whilst the rest is priced according to the current variable rate of your lender. This allows for both stability and flexibility. Allocating a percentage of your loan to a fixed rate might give you more peace of mind when variable rates fluctuate. At the same time, keeping a proportion of your loan variable gives you the flexibility to benefit from offset or redraw capabilities on that portion of your loan and allows you to take advantage of falling rates, if they occur.
It is worth doing your research and speaking with a mortgage broker to consider all the loan options to find the one that best suits you. The rates on offer may also differ, depending on the purpose of the loan.
5. What can I do to ease my mortgage pressure as interest rates increase?
With interest rates on hold or falling for so long, many newer entrants to the property market have never experienced an increase on their interest rate.
You may be able to change your type of loan to help ease any mortgage pressures, but it shouldn’t be a quick decision.
It is important that you consider factors that could affect your finances in the long run. Are you planning to sell your property before you pay off your mortgage? Are you going to start a family soon? Will there be any predictable health issues?
These factors will impact your income and expenses and are necessary to consider before you change what may be the biggest finance loan you have.
If you are in experiencing mortgage stress, and are struggling to make repayments, it would be wise to talk to your lender. They might be able to suggest ways to make loan repayments more manageable, even if it is just a temporary change. This might include swapping to interest-only repayments, restructuring your loan or even accessing excess funds in your home loan (if you have an offset account, it could be possible to use these extra funds for repayments). However, changing your loan could increase the term of your loan and the amount of interest you may have to pay over the long-term, so it is always best to check with your lender or broker and speak to them about your options.
It is important to remember that a home loan is a long-term commitment, and your personal circumstances are likely to change throughout the course of paying it off.
Regardless of interest rate changes, you should frequently revisit your loan and debt structures to ensure you’re getting a good deal and using your loan features or rate splits effectively.
Important information and disclaimer
This document has been prepared by IOOF Finance Choice Pty Ltd ABN 74 129 728 963 ACL 385191 (IOOF Finance Choice). The information in this document contains general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this document you should assess your own circumstances or seek advice from your financial adviser. You should also obtain and consider a copy of the relevant Product Disclosure Statement before you acquire a financial product to determine if it’s right for you. While IOOF Finance Choice has taken all reasonable care in producing the information in this document, IOOF Finance Choice makes no representations in respect of, and, to the extent permitted by law, excludes all warranties in relation to the accuracy or completeness of the information. IOOF Finance Choice, its officers, employees, directors and contractors exclude, to the maximum extent permitted by law, all liability whatsoever for any loss or damage howsoever arising out of reliance, in whole or in part, on the information in this document.