Borrowers are currently indulging in record low interest rates, but what happens when rates start to rise, and mortgage repayments become unmanageable? This article discusses interest rates of the past and uses a case study to show the importance of stress testing a loan.
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!
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.
It isn’t just new borrowers who need to prepare for higher interest rates. It’s the same for those who are refinancing or borrowing for other purposes.
For advice on your debt management, or help with stress testing a loan, talk to your financial adviser.