Is rates rising really THAT bad?

Discussion in 'Loans & Mortgage Brokers' started by spludgey, 20th May, 2022.

Join Australia's most dynamic and respected property investment community
  1. spludgey

    spludgey Well-Known Member

    Joined:
    18th Jun, 2015
    Posts:
    3,483
    Location:
    Sydney
    Let's do a calculation and assume you're on a brand new 30 year mortgage for $1m on P&I at an interest rate of 2%.
    This would mean a monthly repayment of $3,696.20, which consists of $1,666.67 interest and $2,029.53 principal.

    So you might assume that if interest rates were to double, your interest repayment would double to $3,333.33 and your principal would stay the same at $2,029.53, meaning a total increase of 45% which is a fair chunk.

    However that's not quite the case.

    While your interest component does double, your principal repayment is actually less than it would have been with the 2%. It actually drops from $2,029.53 to $1,440.82, meaning that your total monthly repayment at 4% is $4,774.15.

    So your interest rate doubling "only" increases your monthly payments by 29%, in this instance.

    Below is a graph of the monthly principal repayments for the two loans. You can see that the blue line (2%) starts off above the red line (4%), but then after roughly 18 years, the 4% principal repayments overtake the 2% ones.
    Obviously, the area under each curve is the same and equates to $1m.

    upload_2022-5-20_23-34-8.png

    So to summarise, the answer is "No!". Interest rates rising may not quite be as bad as it may first appear.
     
    Terry_w likes this.
  2. Gockie

    Gockie Life is good ☺️ Premium Member

    Joined:
    18th Jun, 2015
    Posts:
    14,742
    Location:
    Sydney
    In the early days of a loan, most of the repayment is interest and only a very small part of it is principal. Only when you get to the later stages of a loan does the principal component of the loan repayment become large and the interest part is small.
     
  3. spludgey

    spludgey Well-Known Member

    Joined:
    18th Jun, 2015
    Posts:
    3,483
    Location:
    Sydney
    Yes. If you select a shorter term length, the difference is even much less pronounced. If you just have a 10 years loan in the example above, your increase in total payments is only 10% even though your interest rate doubled.
     
  4. Gockie

    Gockie Life is good ☺️ Premium Member

    Joined:
    18th Jun, 2015
    Posts:
    14,742
    Location:
    Sydney
    However, you pay interest based on the amount of principal remaining. More principal outstanding (less paid down) leads to a larger amount of interest to pay each month. So overall you’re going to pay a lot more back to the lender if the interest rates are higher unless you find a way to increase your repayments significantly.

    Just found a home loan calculator site that shows it. One is at 2% and the other 4%. The overall interest you pay at 4% is more than double what you pay at 2% because when rates are higher you pay much less principal off in the early years, leading to larger loan balances throughout the life of the loan. 627CB7DB-6D52-4126-BCAD-A9F0723AE310.png 4AC5AC29-6029-4278-B402-15F0646C2AEE.png
     
    Last edited: 21st May, 2022
  5. Rolf Latham

    Rolf Latham Inciteful (sic) Staff Member Business Plus Member

    Joined:
    14th Jun, 2015
    Posts:
    10,599
    Location:
    Gold Coast (Australia Wide)
    Depends where you sit on the IO and PI scale and how many IPs you have going

    .25 % on 3 % IO increases your base cost of interest ( the largest running cost) by 8.3 %

    Using your model of adding 2 %, we end up with 5 % IO , and the percentage of increase is 66.6 %

    On a 500 k loan at 5 % vs 3 % the actual repayment increases from 15 000 per annum to 25 000

    ta
    rolf
     
  6. Trainee

    Trainee Well-Known Member

    Joined:
    24th May, 2017
    Posts:
    10,260
    Location:
    Australia
    Bad only if you cant afford the increased repayments. Even if you dont get cg for a few years, those who have been in it for a while are way ahead of the average anyway.

    But cashflow depends on buffers, what rent does, if you lose your job, if you get pay rises, buffer, share income, cutting spending etc etc etc

    no way to predict completely accurately. Even for your own situation.
     
  7. spludgey

    spludgey Well-Known Member

    Joined:
    18th Jun, 2015
    Posts:
    3,483
    Location:
    Sydney
    Yes, IO will obviously go up by the same proportion as interest rates. If the interest rates double, your IO payment will also double.

    But there are now a lot less people on IO around than there used to be.
     
  8. Rolf Latham

    Rolf Latham Inciteful (sic) Staff Member Business Plus Member

    Joined:
    14th Jun, 2015
    Posts:
    10,599
    Location:
    Gold Coast (Australia Wide)
    One top 5 lender I was chatting with last week said they were close to their IO cap.

    I think that used to be 30 % of NEW lending, over x time, so less that before APRA spoke up, but has gone up again as investor lending has increased.

    Its mainly investors, since very few lenders will do IO on PPOR.

    ta
    rolf
     
  9. Chris B

    Chris B Well-Known Member

    Joined:
    26th Jun, 2015
    Posts:
    221
    Location:
    Melbourne
    While I agree with your calculations, it is a narrow view of the impact of rate rises. The slower reduction of principal has a significant compounding impact over the long term, which means you could easily end up paying more than double the interest over the life of the loan.

    e.g. a $1m loan at 2% (with minimum repayments) will incur interest of $330,628 over 30 years compared to $718,694 if the interest rate is 4%.

    As the majority of people don't keep their home loan for anywhere near 30 years (and when refinancing, will often be encouraged to revert to a new 30 year term), the actual numbers are likely to be much worse. The reduction of the loan principal is going to be painfully slow if you are making minimum repayments and never reach the period of the loan where the principal is naturally being reduced quickly. This is a trap that drastically inflates the banks' profits and leaves homeowners considerably worse off at retirement than if they had been focused on paying off their home loan as quickly as possible.

    This may not apply to most people on the forum, but if many typical homeowners are only making the minimum repayments on their home loan, it is easy to see how many will still owe money on their home when they retire.

    Instead of looking at the differences over 30 years, a more realistic period to compare is having a loan for 5 years:
    $1m at 2% (with minimum repayments) and you still owe $872,044
    $1m at 4% and you would still owe $904,475 but you would have paid an additional $64,680 in repayments, so you are effectively worse off by $97,111.

    Additionally, if the rate stays at 2%, but you make the higher repayments (as if the rate was 4%), your balance would have reduced to $804,079 after 5 years and you would be on track to repay your loan in about 17 years.

    Continuing with this example, if you refinance (or move house) after 5 years and revert to a new 30 year term and continue making minimum repayments, the cycle repeats and the impact of the higher interest rates will increase. Ultimately we don't have much control over what interest rate we pay, but having a plan to repay your home loan by making additional repayments is going to make a massive difference to your overall wealth.
     
  10. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

    Joined:
    18th Jun, 2015
    Posts:
    41,673
    Location:
    Australia wide
    Don’t know if anyone mentioned it above but the extra interest increases deductions too where the loan is used to produce income so this also cushions the blow
     
    spludgey likes this.
  11. MWI

    MWI Well-Known Member

    Joined:
    17th Jul, 2017
    Posts:
    2,287
    Location:
    Lower North Sydney NSW
    So your statement above says it all. ONLY 29% increase in your monthly payments. For some not so bad while for others it may be significant, no?
    Let's say their food bill goes only by 29% extra or their bills etc....
    However, I do like how you illustrated the impact on the actual principal repayments... perhaps lengthening loan terms shifts this curve even further?
    As WB said “Only when the tide goes out do you discover who's been swimming naked."
     
  12. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,130
    Location:
    03 9877 3000
    Interest rates going up is actually a really good thing, as long as wages also increase over time to match the inflation.

    Today you might pay 2% on your loan. In a few years you might be paying 5%. If your income eventually increases the inflation an goes up, then at that point you might say you'll eventually be in the same financial position as you were before the rate increases.

    Then rates start to go down, but your salary stays the same. At this point your home loan becomes much more affordable.

    The real problem is we've only had rates dropping for over a decade. When the inevitable increase does come, the pain is so much worse. The ideal economy would have rates rising and dropping within a 3% margin over a 5-7 year cycle.
     
  13. sash

    sash Well-Known Member

    Joined:
    18th Jun, 2015
    Posts:
    15,606
    Location:
    Sydney
    Lots on here....who are thinking ...that govt will bail things out.... the lack of understanding of economics and how much is controlled by global things...is astounding.

    So yes.... you will soon see who has been swimming naked.
     
  14. Tofubiscuit

    Tofubiscuit Well-Known Member

    Joined:
    1st Nov, 2018
    Posts:
    1,481
    Location:
    Sydney
    We in Australia follow the world. US started the QE and monetary loosening policy, the tide is now reversing.

    The question we need to answer is, are the reasons for this policy reversal controllable by US Fed, if not.... then rate increases is not a choice.

    It may be that recession will come and inflation get flattened since people have no money to spend. Then we will see next round of QE and rate cuts. By then, what will happen to property price?
     
    MWI likes this.
  15. MWI

    MWI Well-Known Member

    Joined:
    17th Jul, 2017
    Posts:
    2,287
    Location:
    Lower North Sydney NSW
    Exactly, time will tell, you said it better, but from past any credit liquidity inflates asset values not just RE but stocks too. However, I believe things need to get worse before QE would resume or some form of aid or interference again.
     
  16. MWI

    MWI Well-Known Member

    Joined:
    17th Jul, 2017
    Posts:
    2,287
    Location:
    Lower North Sydney NSW
    I would add that the purchasing power has a role to play too. Depends whether the inflation was true inflation? We can have pay rises which are overall lower hence making some poorer.
    Let's look at private school fees or private medical surgeries, I think they have been rising over decades much higher than any underlying inflation. But overall agree that inflation rising means economy is rising too....
     
  17. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

    Joined:
    18th Jun, 2015
    Posts:
    8,130
    Location:
    03 9877 3000
    You're right, pay rises don't get distributed evenly. I've also thought about this in terms of who the average borrower might be.

    For the first home buyer, they're probably at an age where they'll experience faster salary increases. A persons salary tends to start low in their 20s, but increases as they get promotions or change employers. My own salary doubled within the first 3 years.

    People in their mid to late 40s are approaching the maximum salaries they'll likely experience.

    Unfortuantely in your 50s salary is likely to stagnate and possibly reduce in real terms when inflation is considered.


    You can also offset all of this against the cost of living. People might argue in their 20s that their cost of living is high, but many don't have children and spend a lot of money that others might consider discrssionary. In your 30s and 40s people experience a reduction in one income, plus increased real expenses as a result of raising children. Hopefully these expenses disappear in their 50s or 60s as the kids leave home.

    Overall I'd say people are most likely to experience mortgage stress early on. Things do get easier over time due to a number of facts but there is also likely to be periods where people individually experience financial stress for any number of reasons.
     
    MWI likes this.
  18. Marg4000

    Marg4000 Well-Known Member

    Joined:
    18th Jun, 2015
    Posts:
    6,380
    Location:
    Qld
    Most people who have had mortgages for some years were advised not to reduce payments as interest rates dropped, so should be insulated from the impact of at least the next few interest rate increases if they followed that advice.
     
  19. MWI

    MWI Well-Known Member

    Joined:
    17th Jul, 2017
    Posts:
    2,287
    Location:
    Lower North Sydney NSW
    Agree, many have buffers, whether directly in prepayments, offsets, or other.
    Any burden will be felt by some only, like in real life.
     
    Marg4000 likes this.