Grow Magazine

The lure of low rates

September 2016

The pros and cons of borrowing in a low rate environment

Do record low interest rates make it a good time to take the plunge and borrow to invest? By Gale Bryant.

In August, the Reserve Bank of Australia reduced the cash rate to 1.5 per cent and economists are predicting further cuts over the coming months. But while the situation means the cost of borrowing is low, is it necessarily a good time to take the plunge?

MultiForte director Kate McCallum says the question of whether it’s a good time to borrow depends very much on an individual’s personal situation and what he or she wants to achieve.

“A borrowing decision should never be made in isolation,” McCallum says. “There are pitfalls and one is the possibility of rate rises. A good rule of thumb is to consider your ability to service a loan if interest rates were 2 per cent to 3 per cent higher than they are today. It’s important to ensure you can still make repayments if rates rise.”

Building a buffer

It’s not just rising rates that need to be considered. Borrowers should also factor in a decline in their income, such as through a job loss.

McCallum says if someone is borrowing to buy an investment property, they need to be aware there are periods where it could be untenanted – perhaps due to a tenancy changeover or major repairs being undertaken.

“Investors need to consider a decrease [in], or an inability to increase, rents,” she says. “Rental returns appear relatively low currently and may come under further pressure with new apartments being released. I would usually suggest that people have at least six months’ salary as a buffer so that they are not under financial stress if things don’t go according to plan.”

Nathan Birch, co-founder of property investment group Binvested, says when buying property, there are a number of things investors should consider. “They should make sure it’s below market value so they are making a profit from day one,” he says. “Buying below market value isn’t easy – you need to take your time and do your research properly to be able to identify which properties are below market value that you may be able to get a deal on. They should also have a buffer in place in case rates rise.” A strong cash flow is also required, Birch says.

“Everyone emphasises the benefits of negative gearing, but negative gearing will eat into your lifestyle and if something goes wrong you need to know how long you can last before you go broke,” he says. “If you have a property that’s looking after itself then the rent will pay for the mortgage and all the associated rates.”

Negative gearing remains a political hot potato and while no immediate changes are planned for the policy, this may change at some point.

His final piece of advice is that property investing should be viewed as a business. “Potential investors need to look at the numbers, as the numbers don’t lie,” he says.

“They need to know how to work a budget and know what their goals are. Before buying any property people need to understand why they are buying it – is it going to help you get closer to your goals?”

Stress-test your risk levels

Borrowing to invest in other assets, such as shares are also worth a look in a low-rate environment, but again, investing in them is dependent on each individual’s situation, time frame to invest, risk tolerance and capacity.

With shares, McCallum says a significant issue is volatility. “As share prices can move substantially, you need to be able to tolerate assets dropping – on paper – by amounts as large as 40 per cent,” she says.

A fall “on paper” will impact investors if they need to sell at a time when assets have dropped in value.

McCallum says investors also need to be able to handle long periods where shares don’t appreciate in value. “If you use a margin loan to borrow, then you may be subject to margin calls, which means that you need to have additional cash to top up your loan.”

A margin call may also require you to sell at a time you don’t want to if you don’t have the money to top up your loan.

Jonathan Philpot, wealth management partner with HLB Mann Judd, doesn’t believe rates will rise for a while so he thinks there’s not too much risk they’ll spike sharply in the next few years. When it comes to borrowing to invest in assets such as shares, he’s personally not a fan of margin lending.

“Too many people get caught out doing exactly what you shouldn’t do – i.e. having to sell at the bottom of the market,” he says.

“If you have equity in your home, you could take out a separate loan and invest in shares that way. But you should make sure your approach is treated as a long-term investment and not get too jumpy when markets go down.”

He adds the good thing about shares is that with the high-dividend yield at the moment, you could probably be in a slight positively geared position with the dividends and franking credits being higher than the interest repayments on the loan.

Philpot says for retirees living off their investment wealth, the low interest rate environment is likely to be hurting them. “They need to be careful not to be too conservative with their investments so they’re not eating into their capital each year,” he says.

Philpot notes retirees may need to consider taking on a little bit more risk within their investment portfolio as fixed interest returns may not be enough to generate the income people need.

Meanwhile, McCallum recommends investors consider well-diversified portfolios, as predicting asset-class returns in advance is extremely difficult. “If an investor is constantly searching for a portfolio comprised of nothing but positive performing instruments, then they’re likely to incur additional costs and risks,” she says.

These additional costs and risks are a result of actively managing investments, where equities are bought and sold more frequently. Wealth-management strategies require an approach that balances risk and return – and each strategy is dependent on an individual’s own needs and goals. Seeking the advice of a professional financial planner may help clarify investment objectives and how to achieve them.