Making the most of low interest rates

Everyone knows that interest rates in Australia are lower than they have ever been, but no one knows with certainty what the future holds for rates. Even the most seasoned commentators were surprised with the latest drop after the Reserve Bank’s May meeting.

Most predictions are that they will remain at the low end for some time to come, so while borrowers love low rates and savers curse them, what can be done to make the most of the situation?

Yay!

Major winners of declining interest rates are households with mortgages that were taken out at a higher rate. Keeping up repayments at the original level will see the mortgage paid ahead of schedule, delivering a big reduction in the total interest bill.

Property investors can also be winners, particularly when buying property away from the high prices and low rental yields of inner city areas. However, care still needs to be taken to avoid excessive debt that could have a disastrous effect when rates rise.

Businesses benefit from a low and stable interest rate environment. It’s cheaper to borrow to grow the business; and a major reason why the Reserve Bank lowers interest rates is to stimulate business investment.

Boo!

For everyone cheering on low rates there will be someone booing them.

In recent years, people who depend on term deposits, high-interest savings accounts and bonds have seen their interest income fall by more than half! Self-funded retirees are particularly affected, especially where interest payments make up most of their income.

Low rates aren’t always the friend of new entrants into the housing market as commonly touted. Low interest has been a major contributor to the rise in house prices, saddling new borrowers with higher levels of debt. The lower rates go, the less room there is for further cuts. With higher debt, any future rate rises will bite harder, so new borrowers need to carefully assess their ability to meet loan repayments when interest rates do rise. It’s also a good idea to reduce debt whenever possible.

Life is also difficult for investors, including everyone contributing to superannuation. The low yield from conservative investments (cash and fixed interest) means there is a greater ‘cost’ in minimising portfolio risk than has previously been the case. One consequence of this is to drive many investors to search for other investments that offer higher cash returns at a potentially higher risk.

Looking for yield

While a bank share paying a 10% dividend (including franking credit) looks very attractive beside a term deposit offering 3% interest, it needs to be remembered that, in the current climate, any effort to increase yield comes with an increase in risk. Even so, high yield shares can be a viable option for some investors who need a regular income.

Other options might include:

• Corporate bonds and floating rate notes. These are issued by publicly listed companies, so are not as secure as government bonds.

• Hybrid securities, such as converting preference shares. These offer a more stable income stream and tend to be less volatile (risky) than regular shares.

• Property trusts. Yields can be attractive, but they can be as volatile as shares.

What to do?

The best way to navigate the world of low interest rates depends very much on your personal circumstances. Good advice is critical, so talk to us if you’d like to learn more.