Use judgment: Make sure you are not overstretched should interest rates rise. Photo: Rob Homer
Last week’s strong property markets in the major capitals during a normally slow winter period provide further confirmation that low interest rates are encouraging investors to take higher risks. While the share market is still on average 20 per cent (or more if allowance is made for inflation) below its previous peak, residential property prices in key areas are now reaching record levels.
While this could normally be expected to make major lenders more cautious in writing new loans, if anything, competition for new business has increased. The latest way of attracting new clients is by offering three and five-year fixed-rate loans at interest rates below 5 per cent a year.
At the same time, the Reserve Bank is expressing concern that many recent borrowers are likely to experience difficulty in servicing their commitments if interest rates rise substantially. The obvious way for borrowers to guard against this is to fix all or a large part of their borrowing costs at the current attractive rates for as long as possible.
Despite more fixed loans being taken out, most owner-occupied and investment borrowers choose the standard variable rate option. This has been a good decision during the past two years. However, with overseas interest rates, especially in the US, likely to increase in the next year or two, fixed-rate loans are now looking more attractive.
While fixed-rate loans provide short and medium-term protection against the possibility of interest rate rises, they can still increase overall investment risks by encouraging larger borrowing commitments because of the comparatively low costs incurred.
Relatively high levels of gearing are involved with most property purchases. This can and often does involve complacency about the risks involved with gearing including from interest rates rises and the loss of employment. Very rarely do the purveyors of loans concern themselves with the need to counsel borrowers about the risks of loans, even for those with high loan valuation ratios (LVRs).
Moreover, unexpected interest rate rises can have a double-whammy effect on overstretched borrowers. The immediate impact is the cost of servicing variable interest rate loans. But higher interest rates are also likely to reduce the options available to borrowers to sell their property at a realistic price. Being forced to sell a property in the current buoyant market is not the problem that it will be if interest rates are higher and an increasing number of owners are being forced to sell.
The key message is that as well as considering the pros and cons of fixing the rate on some or all borrowings, investors need to be conscious of the risks of borrowing more than they can afford if interest rates increase.
Daryl Dixon is Dixon Advisory's executive chairman.