A practical look at interest rate hikes…
As mentioned on our Facebook page in January, the South African Reserve Bank recently raised interest rates for the first time in years. I wanted to take this opportunity to expand on the subject and to provide some practical insight on how this impacts your personal finances and the way in which you should potentially deal with your financial strategy/plan.
Impact on outstanding debt:
When you borrow money, in whatever form that takes; bond on the house, vehicle finance, personal loan or credit and store cards, you pay a rate of interest which is in some way linked to the official interest rates set by the SA Reserve Bank. You’d do well to consider this interest rate your ‘cost’ of money. As interest rates rise the ‘cost’ of the money you borrow therefore goes up and the payments you are required to make monthly also go up.
The official interest rate set by the Reserve Bank is called the ‘Repo rate’ and this currently sits at 5.5%. The loan rates we typically receive however, are linked to another rate called the ‘Prime Rate’ which is currently set at 9.0%. Your home loan and vehicle finance will usually be expressed as prime plus x%.
Ideally individuals would pay down (reduce) their outstanding debts when interest rates are low or the cost of money is cheap. But inevitably ‘cheap’ money is marketed aggressively by lending institutions (banks, stores and personal loan companies) during these periods and consumers use this as an opportunity to use loans/credit to buy things that they need, want or, as is often the case, things they neither need nor really want.
It is important to understand how changes in interest rates affect the affordability of the things you buy so that you do not find yourself losing your possessions when the inevitable interest rate cycle turns as we have seen evidence of with last month’s rate hike.
If you have a bond on your house with R2 million outstanding and you pay 11% per year currently, a 1% increase in interest rates will see your monthly bond payment increase by almost R1,200 (R14,300 per year). If at the same time you have a car loan outstanding of R250,000 and you currently pay a rate of 12% on this, then a 1% increase in interest rates will equate to a monthly increase of nearly R140 (R1,680 per year). Ignoring any other credit card, store card or personal loans you may have, that means you will have to come up with an additional R16,000 per year to cover your debts.
Even after the 0.5% increase in interest rates in January we are still at very low levels historically. The average interest rate since 1998 is around 13.5% but this includes a brief spike out to around 24% (yes 24%) when Chris Stals was trying to defend the Rand by raising interest rates. So even if rates only go back up to a more normalised 8.5% from here, that is another 3% or close on R50 000 per year extra you will need to come up with to service your house and car payments.
Tips to consider:
Make sure that your decisions today reflect the strong possibility/probability of higher interest rates from here.
Pay down your existing debts, preferably the most expensive first which are likely to be store and credit card debts and then tackle the larger ones like your vehicle and eventually the house.
Start to live within your means and do not incur further debt, especially for non-essential items.
If you have stores cards with an interest free period, make sure you pay down other debts which are currently incurring interest payments first.
If you have outstanding short-term debts consider wiping these out before you start an investment or savings account, as the interest you are charged is likely to be well ahead of any real returns you will achieve from your investments in the current environment.
If you are considering new purchases then make sure you factor in further rate hikes when considering the monthly payment affordability. If you do not know how to work that out find someone you can trust who does – Hint: this is unlikely to be the sales person trying to close the deal with you.
Interest rate hikes and your investments:
We would need to write an essay or two to properly cover the impact of interest rate hikes on your investment strategy and portfolio in any detail but a few general thoughts to consider:
Equities/Shares – Because interest rate hikes are usually the result of inflationary pressures, periods of interest rate hikes are frequently associated with positive equity market performance (At least initially). Companies are generally expected to grow sales and profits ahead of inflation assuming they can pass on cost increases to their end consumers. The exceptions to this rule would be companies that have excessive amounts of debt on their balance sheets for reasons similar to those of individuals that we touched on above. The local share market may also be damaged by an outflow of foreign investors attracted back to their home markets by more attractive interest rates.
Bonds – Rates hikes are generally negative for bond investors as bond prices will fall as interest rates go up or in anticipation of interest rates going up. Put another way: If someone offered to pay you 6% for the next three years if you lent them R100,000 today but you expected in one year’s time that you could lend that same money to someone who would pay you 9% why would you lend them the money now?
Furthermore, Inflation serves to reduce the real returns that you receive from fixed income investments (excluding inflation-linked bonds). If inflation goes up, fixed investment income payments/coupons (like most bonds pay) become less attractive in real terms and people sell bonds causing prices to fall.
Cash – The rate or return you receive on cash savings should go up with interest rates. Of course you still need to be aware of the real return that cash provides rather than the face value or nominal return (before inflation). If you earn 6% interest on your cash investments and inflation is 6% then that is the same real return (0%) as if you earn 12% on your cash investments and inflation is 12%. All investments should focus on earning real returns to create wealth.
Property – Most property investments are funded by long-term debt so when interest rates go up their costs go up. Property returns (rentals) can usually be increased in line with inflation so the attractiveness of property when rates go up depends on the ability of the property companies to increase their rental income ahead of costs (interest payments). Typically, property investments (prices and rental yields) offer good protection or insurance against rising inflation.
Retirement income – Pension payments (annuity rates) are linked to long-term interest rates so higher interest rates should translate into better annuity rates offered by the main insurers (Income payments in retirement). Once again however, it is important to ensure that the annuity product you choose in retirement, increases payments in line with, or ahead of, the inflation rate or the general increase in the cost of living.
If you have any questions or want further advice on how to structure your investments or improve your personal finances please contact us at firstname.lastname@example.org
You can use our Personal Finance Spreadsheet to help you calculate the impact of a change in interest rates on your monthly re-payments here.