It’s hard to imagine taking out a
home loan with an interest rate of 17% per annum or higher, yet that was the
reality for homebuyers in the late 1980s and early 1990s. And back then it
would have been just as hard to imagine home loan interest rates of less than
3% p.a.
The point is, ultra-low interest
rates are not the norm, and while it might be tempting to load up on debt when
interest rates are very low, it’s important to understand what can happen to
loan affordability when interest rates rise.
A
(very) simple example
Sarah and Evan have just taken out a
$500,000 variable rate owner occupied home loan at an interest rate of 3% p.a.
With a 25-year term the repayments are $2,371 per month. But what happens if,
overnight, their interest rate jumps to 8% p.a.? Those repayments would
suddenly become $3,859, an increase of $1,488 per month.
Of course it’s extremely unlikely
that interest rates would double or treble overnight, but even under a more
realistic scenario the results are not vastly different.
Let’s look at Sarah and Evan’s
situation if, on each anniversary of the establishment of the loan, the
interest rate rises by 1%. After five years the interest rate has risen to 8%
p.a., and if the loan repayments have been adjusted on each anniversary to
maintain a repayment time of 25 years, Sarah and Evan will still have an
outstanding loan balance of $442,490. It will take monthly repayments of $3,701
for them to pay this off within the original term.
This is $1,330 more than their
original monthly repayments, or $15,961 per year. That’s enough to put a real
strain on most household budgets.
Easing
the immediate impact, but with a sting in the tail
When there are small, incremental
increases in interest rates, lenders may not automatically increase monthly
repayments. Rather, and usually with the agreement of the lender, they may
increase the term of the loan. This takes the immediate strain off household
finances, but may add many years to the term of the loan and thousands of
dollars to the total interest bill.
The willingness of a lender to hold
monthly repayments steady will depend on your repayment history, the level of
equity you have built up in your home, and the size of the rate rise. In our
first simple example, the interest component alone would exceed the initial
repayments well before interest rates got to 8%. The loan balance would grow
rather than decrease!
Stress
test
This shows how important it is to
‘stress test’ a home loan, or any loan for that matter. Ask yourself: can I
service this loan if interest rates increase by more than a particular amount?
And what should that amount be? Many lenders use a buffer of 2.5%, so a 3%
interest home loan would be stress tested at 5.5%. However, future movements in
interest rates are notoriously difficult to predict and cautious borrows might
want to use a higher interest rate in their stress test.
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