In the first week of July the Reserve Bank of Australia dropped the official cash rate to 1.0%, the lowest is has been since the 1950s.
It was the second rate-reduction of 0.25% in two months. The RBA has reduced the cost of borrowing money to such levels in order to keep consumer price inflation inside the 2-3% band that is considered the healthiest inflation rate for the economy as a whole. But beyond broader economic considerations, the rate reduction has some implications for individual investors.
In the first place the low ‘cost’ of money makes borrowing a cheaper option, while at the same time it erodes returns in ‘cash’ investments such as savings accounts and ‘fixed interest’ funds.
Therefore, the extent to which you can make low interest rates work for you will be greatly influenced by your stage of life and your tolerance towards investment risk. The lower cost of debt opens opportunities to buy assets (usually property and shares). Similarly, those with surplus cash holdings could be hunting for better returns on their money. If you're confused about your life stage and risk profile, see a Wealth Market Financial Adviser to ensure your investment horizons match your needs.
Looking at low interest rates from the debt perspective, the RBA’s cash-rate reductions make home loans even cheaper than they were at the beginning of the year when the cash rate was 1.5%. Some owner-occupier mortgages are being marketed at 3.0% pa.
One way to use these low rates is by borrowing to invest in your primary residence – either by buying a new home, renovating or refinancing your existing mortgage to a lower rate. However, always be aware that cheap debt is still debt, and low interest rates will some day trend upwards.
Conversely, consider using low-interest rates to pay-down your loan faster by putting extra repayments into your mortgage and getting ahead on your equity. Reducing your primary residence home loan can make good sense if you are in pre-retirement mode.
Low interest rates can make it more affordable to buy an investment property and become a landlord. However, before buying investment property, get independent advice about your life stage, your tax position and your suitability for this investment.
What if you have money in savings, and investments in managed funds and superannuation? What do low interest rates mean for you?
With money in savings you have to ensure that your investments return more than inflation. If you earn 2.0% pa interest on your savings, and inflation is 1.8%, your real yield is very low.
Higher returns usually mean greater risk. So in a low interest rate environment, people with cash should consider the suitability for investments that are slightly higher risk than cash, for at least some of their savings.
A similar situation exists in superannuation funds. Many unknowingly have their retirement nest-egg invested in conservative investments – such as ‘fixed interest’ – with yields that might barely exceed inflation, depressing the overall returns you might have expected from your super.
The long-term ramifications of having most of your retirement savings in fixed-interest options, can be troublesome. With the high average life expectancy for Australians, it’s worth having an investment plan that lasts as long as you do, rather than parking your money in the lowest-risk asset, especially when interest rates are low.
Talk to a Wealth Market Financial Adviser about the other low volatility options, where your returns have the potential to be higher than cash, without taking a lot more risk. This slightly better return – without a lot more risk – will help you stay ahead of the dilutive influence of inflation. If you’re not sure what options your super fund contains, find out or ask your Wealth Market Financial Adviser.
Low interest rates represent challenges for some investors, and benefits to others. If you don't understand the loan, the investment, the risk/return or the tax implications, seek professional advice, and make low interest rates work for you.