This is one of the simplest of the risks to understand for most property investors.
Any debt you hold on variable terms is subject to any future rate rises either by banks ‘out-of-cycle’ or increases to the cash rate by the Reserve Bank of Australia.
While fixed rates do insulate you form this risk for a period of time, they too will revert to the variable rate eventually. As such, your interest rate risk is really driven by finance market wide factors or by domestic and global economic conditions, things you have no control over.
So the question is what rate rises should you buffer into your situation? In our view, a 5-year horizon is a good timeline to consider this.
Trying to estimate rates over an entire 30-year loan term is far too much guesswork, and considering a shorter time period than 5 years means you may not be adequately considering potential longer term risks. A 5-year horizon is a good balance between being long enough to consider long term risks but short enough that you can map it out with a reasonable degree of confidence. Time to bring out your inner economist!
So let’s come up with our 5-year projection. First, let’s analyse the status quo. Interest rates are currently quite low by historical standards. Economic growth and wage growth are also relatively weak across the western world and has been since the 2007 financial crisis. Inflation has also been weak for an extended period, though some key countries, such as the United States and Germany, have shown signs of recovering inflation recently (as at May 2017).
The second step is to consider what we can take out of the status quo to gauge the next five years. A low growth, low inflation environment tends to suggest incremental improvements in economic conditions rather than a ‘boom’ environment. Likewise, this also suggest incremental, controlled movements to the cash rate by the RBA.
The final step is to put a rough number on this we can use for our calculations.
This number need not be precise, but if you are in doubt it’s better to lean more conservatively. In our model we use a 1.5% rate rise as our buffer figure based on some detailed modelling we’ve undertaken, but feel free to input the figure you arrived at from your consideration. At the end of the day these figures are all just estimates! That said, we feel it is very possible that in 5 years the standard variable rate you will be payable could be 1.5% higher than today. More than that gets a little bit less likely based on our modelling, and less than that probably undersells the risk