Real Estate

Investing in Real Estate 111 (Interest Rate Changes)

Reading Time: 9 minutes 

“Buffering…please wait…buffering… please wait…”

Ever recall that message come up before?

Well, before the age of high-speed internet and insta and snap and YOLO, us millennial folks who grew up in the 90s sure can.

We who grew up in the age of the Pentium 3, the 56k modem (brrrkrrr… beep…krrr…dookrrrrr dookrrrrr…) and the Nokia 3210 – we remember.

Image result for nokia 3210
Rest in peace old friend.

Because we used to get that messages ALL the time.

As a teenage boy, the frustration of seeing that pop up when trying to download por… maths papers was palpable.

“I REALLY need to do some mathematics, RIGHT NOW”.

I used to say out loud to no one in particular (this is because I was always alone when doing maths papers, helps one to concentrate you know).

Back in those days, you would run the risk of the dreaded buffering message each time you clicked on a website, speaking of which… buffering… buffering… buffer…HEY wouldn’t you know – buffering is part of what our post is on today!

Which, incidentally is the final part of Bane-san’s question:

How to start a property portfolio (and how to get/ structure loans for this), how to prepare for inevitable increase in interest rate.

You can read the first parts of the question here and here, as this post focuses on the final part – preparing for the inevitable increases in interest rates.

Image result for knight
Come at me bro!

Incidentally, my friends Light Beam, Bike Bao and I were discussing this very topic today.

The consensus from Light Beam out of Canberra, is that interest rates are likely to be on hold for a very long time yet.

Hopefully Light Beam is right, but even still – now, more than ever – is the best time to prepare for when they do move.

So how do we protect ourselves then?

For a start, we need to understand that it is a question of when not if interest rates will rise.

The RBA cash rate is at historical all-time lows for the longest stretch anyone can remember:

RBA-cash-rate-changes
Hey that looks like the snake game on our beloved Nokias!

For the likes of you and I, interest rate movements have significant implications for our greatest expense when it comes to property – that is, our loan repayments.

Given interest rates are at historical lows, our repayments correspondingly are at record lows – which is a big catalyst of the great Sydney and Melbourne boom of 2012-2017.

However once rates track up, expect to see more pain than gain in our housing markets as our highly indebted households feel the strain.

So back to Bane-san – what can we do to prepare ourselves?

Refinance our finances

Amidst the rising interest rates and tighter lending regulations, we might decide to opt to refinance our property to either a) move to a cheaper rate lender or b) access equity.

The benefits of moving across to a cheaper rate speaks for itself, but what about accessing equity?

Image result for destroying a building gif
“Hi, my name is Godzilla and I’m here to access equity”.

By accessing equity we can either continue purchasing properties to leapfrog our portfolio or more importantly, obtain a line of credit against our property we can use for emergency purposes.

A big issue to watch out for is that many people borrow the absolute maximum the banks can lend straight away – thereby capping out their servicing or equity component until an increase in property value and/or personal income. 

Refinancing also allows us to have our property re-valued formally.

Mitigate the mitigants

Major considerations with loan repayments are stability of your primary source of income (job), stability of rental income, your future personal circumstances (e.g. having a baby) among others.

There’s no point worrying about interest rates when you can’t afford to repay at current rates.

If you don’t have the income or you don’t have a tenant, if your borrowing is on a shoestring to be able to meet the commitments, you need to be very careful of borrowing money because that’s how you lose money on properties, by being a forced seller.

Related image
“Hello, it’s me again – yes I’m also a force seller”.

That’s one of the major risks: you overextend and you can’t afford it. Some people on the East Coast may have already stretched themselves too far this time round. 

Can you test my stress

Which is why it’s always a good idea to stress test any borrowing repayments. Luckily (or unluckily) the banks do this for us.

Any borrowing application is reviewed with higher “assessment rates” (which is usually a few percentage points higher than actual rates).

You can also use this as a guideline:

“That’s going to be my benchmark. I have to factor in a two or even a four percent increase in interest rates. What will happen if I have to pay that?”

Image result for bankruptcy
This will happen.

Be aware though, that rates in Oz very rarely (if ever) move by more than 25 basis points at a time – if you’re worried by a move of a quarter of a percent… then you should seriously re-consider your position.

My principal interest is interest-only

In the current climate, it’s clear that the lenders and banks prefer us to repay our debt. Traditionally, I mentioned (here) they would have been happy to keep on lending at interest-only terms.

However nowadays a pricing differential between P+I and IO lending has developed, with P+I rates usually lower than IO rates.

This is a way for the banks to signal to the market that the preference is a) debt reduction, b) artificial equity increase and c) slow-down in lending growth – as P+I means a higher cash flow requirement.

Warren Buffer(t)

No, not a buffer when Buffet eats a buffet, but a buffer against adverse circumstances.

A buffer is basically a barrier against bad shit happening to you.

Image result for godzilla gif
“Hi there, me again – I also create bad sh…”, “FUCK OFF GODZILLA”, “oh…o…ok…”

In our case, a rise in interest rates, a sudden loss of job or extended tenant vacancies can be defined as “bad shit”.

Which is why we need a cash buffer against all the rough times.

Personally I’d like to have a minimum of 6 months of loan repayments as cash sitting in offset accounts for those just in case scenarios.

~~~

As you can see, protection against a rise in interest rates is more about your cash flow than anything else.

The key is to look at your cash flow position and not to focus on the interest rate. 

And the best way to check that you have everything in order correctly is to undertake a thorough and regular loan review. Schedule it in with your mortgage broker or financial planner and keep on top of your loan strategy.

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