Investing Strategically With Higher Interest Rates

For some years now, the decision to borrow and invest has been slanted in the borrower’s favour – cheap money on the back of an RBA target cash rate of 0.1 per cent for an extended period of time meant that the investments – shares, business or property – did not have to produce a great deal of income to cover the borrowing costs.

It is now history that over the past 10 months or so, the RBA has lifted the target cash rate from that historical low to 3.35 per cent, with ASX cash rate futures, as of 17 February, expecting a peak of 4.1 per cent towards the middle of this year.

This fundamentally changes the landscape for those who have borrowed to invest.

The cash flows from investing and borrowing are now likely to be reversed, with the income from a property or share investment no longer covering interest costs. Assuming a borrower is paying around 200 basis points above the target cash rate, they will be paying loan interest of around 5.35 per cent. While there are some tax benefits from negative gearing, even after tax the change in cash flows will have been significant.

The Risks From Higher Interest Rates

There are four important risks that change for people borrowing to invest as interest rates rise:

• The risk created by higher interest repayments
• The increased risk of not being cover higher interest repayments in the event of challenging financial circumstances (e.g. a period of not working)
• The risk of a fall in asset prices
• The risk of changes in loan conditions – especially loan-to-value ratios in margin loans

Let’s look at these in turn.

Higher interest costs immediately put pressure on the cash flow of any investment situation, and any cash used from other sources – for example, from employment income. The maths of this is straightforward: with the target cash rate at about 0.1 per cent, a loan with an interest rate of 2.1 per cent (200 basis points above the target cash rate) cost $2,100 for every $100,000 borrowed. With the current target cash rate of 3.35 per cent, the same $100,000 loan is now costing $5,350 in interest (assuming an interest rate 200 basis points above the target cash rate).

This is a challenge in itself and also leads to the second risk – how well positioned is someone if a financial challenge strikes? Let’s make some assumptions to illustrate. If the borrowed money was for a portfolio of shares with an average yield of 4 per cent per annum ($4,000 on a $100,000 investment) with a 2.1 per cent borrowing rate the income from the shares was comfortably paying off the interest on the loan. With the current borrowing rate of 5.35 per cent, suddenly the $4,000 per month income leaves a $1,350 shortfall, making it another expense that might be difficult to manage if personal financial circumstances are challenging – for example, not having employment for a period of time.

The third risk is that of falls in asset prices. At the moment, the share market is a little under all-time highs and residential property values have fallen as interest rates have risen. The hidden trap in these circumstances is what might happen if interest rates rise further than currently expected, pushing the price of share and property investments down.

Tricky Situation

The combination of higher interest costs and falling asset prices can make for a tricky situation to navigate. If an investor is thinking that the forecast for interest rates seems to be around another 0.5 per cent to 1 per cent of rises and that is manageable – keep in mind that 12 months before these things happened, very few people were forecasting either 0.1 per cent interest rates in 2021 or 3.35 per cent interest rates now. Forecasts might be wrong again.

Finally, we look at one of the structural challenges of margin loans, the ability for a lender to change the loan-to-value ratio (LVR) of an asset. In simple terms, a lender might change the amount that they are prepared to lend against an asset (in terms of margin loans, which is the main concern, the amount they are prepared to lend against a share).

If this happens against a few shares in a portfolio, suddenly the amount the lender is prepared to have in your loan reduces, and you have a few days to either provide additional shares or money to your loan facility. As higher interest rates require higher regular interest repayments, there might be less cash on hand to manage that situation.

Often margin loans have higher interest rates. If a person has the capacity to access other credit, for example borrowing against their property, this might be a cheaper option without the uncertainty of possible LVR changes.

Taking Action – Steps to Consider

Having defined some of the increased risks of an investment loan in a time of higher interest rates, it is worth considering what action you might take if you have concerns about the size of your investment loan in a rising interest rate environment.

The first resource that an investor can utilise is their current surplus income (from dividends, rent or salary/work earnings). Now might be a time to be conservative with this, using it toward paying down any loan that is creating financial pressure. It is worth remembering that every extra loan repayment reduces every future interest cost.

If this is not enough to create confidence in the financial situation, then considering paying off some of the loan as the next step. This might be challenging with a property investment loan. However, share investors might be able to sell shares to reduce their loan balance – and with the share market not far from record highs, now might be a reasonable time to take action. An investor with a margin loan who wants to reduce the exposure to LVR lending rules could do so by selling some shares and reducing the size of the loan.

One key strategy to consider that might provide peace of mind if there is concern about the ability to cope with challenging financial situations might be the use of income protection insurance. This replaces part of your income in the event of serious illness or injury. It is important to keep in mind that income protection insurance does not provide a payment in the event of losing a job and will not help someone cope with all financial situations.

Finally, with interest rates changing so quickly it is worth checking that you are paying a competitive, low rate for all of your loans, investment or otherwise. Ten minutes spent on a comparison website looking at loan options should either provide you with confidence that you are getting a good rate, or the information you need to call your lender and either negotiate a better rate or move from your current lender to a better option.

Conclusion

In less than a year the RBA target cash rate has increased from 0.1 per cent to 3.35 per cent. While this is great for investors in cash, for those who have borrowed to invest, the balance of cash flows have likely changed from surplus to deficit. Thinking strategically about what to do now – whether it be extra repayments, paying off a lump sum of the loan, taking out income protection insurance or renegotiating the loan – will leave leveraged investors in better shape to cope with any future interest rate rises.