2017 is coming to a close and what an ‘uninteresting’ year it has been.
Earlier this week, for the 13th month in a row, the Reserve Bank of Australia (RBA) left the official target cash rate unchanged. This means that Australian interest rates have been at record lows for all of 2017. Obviously, this has never happened before.
The RBA meets each month to set its target for interest rates throughout much of the economy. It does this by setting a target rate for one particular interest rate, known as the ‘cash rate.’ The cash rate is the rate at which banks lend each other money on an overnight basis. By setting a target price for this market, the RBA affects the other major markets in which money is borrowed or lent.
Record low interest rates won’t last forever. That’s the whole point of being a record low. At some point, interest rates will rise again. Some economists are predicting a rise next year. Others are saying the rise will come at some more distant future point. But it is a question of when, not whether.
So, what should you be doing in 2018? As financial advisors, we usually divide interest into two types: deductible and non-deductible. As the name suggests, deductible interest reduces your tax liability. Deductible interest occurs where the borrowed money is used for some income generating activity, such as investment. Non-deductible interest occurs where the borrowed money is used for some private purpose, such as buying your own home.
Given the tax differential, non-deductible debt is usually more expensive than deductible debt, even if the interest rate is the same.
Interest is the price of borrowing money. In most markets, when prices are low it makes sense to buy more of that particular item. If tea bags are on sale, buy two packets. But when it comes to non-deductible debt, it can make sense to take the opposite approach. While interest rates are low, it makes sense to take the opportunity to repay as much debt as possible. This means you will have less debt when interest rates inevitably rise.
Repaying debt is a different way of ‘stocking up’ for the future.
A simple way to do this is to assume that interest rates have already risen. Let’s say you have a home loan and you are paying interest at 4.5%. On an average loan of $350,000, this is $15,750 in interest each year, or $1312 each month. If you only pay this amount to the lender, the amount of debt (‘the principle’) stays the same. But every dollar above $1312 that you repay will reduce the amount of the loan that is outstanding.
Most lenders require a monthly repayment that is greater than just the interest, so that you have to repay some of the actual debt each month. However, most borrowers can also make additional repayments that will reduce the amount outstanding even further. One simple way to make extra repayments is to assume that interest rates are actually 5.5%. The extra 1% of interest would equate to $3500 per year, or $291 per month. So, you add $291 to whatever monthly payment the bank is requiring you to make. This will give you at least three benefits.
Firstly, you will repay your debt more quickly. Basically, you will pay off an extra $3500 of your debt each year.
This might not sound like much, but it leads into the second benefit, which is that the amount of interest that you need to pay in future years will also be reduced. 4.5% of $3500 is $157. So, paying off an additional $3500 worth of debt will save you at least $157 every year from now on. This means that you will be able to repay a further $157 of principle next year without increasing your repayments. You start to get a little snowball effect happening. Of course, when future interest rates rise, the annual saving will rise as well.
The third benefit can be a little less obvious. As we say above, the next move in interest rates will almost certainly be up – there is not much room for the next move to be downwards. Because you are making repayments as if interest rates were higher, you have already set your family budget to reflect a higher interest rate. So, your budget won’t be as strained when interest rates do actually rise. While everyone else will need to reduce their personal spending to accommodate the extra interest, you won’t. (Of course, you could decide to continue to make extra repayments – and when it comes to non-deductible debt, we think you should. But the point is you won’t have to).
So, as 2017 comes to a close and record low interest rates remain a reality, it makes sense to plan for the day when interest rates will rise again. Make 2018 your year of repaying non-deductible debt. That might make it your best year ever.