The True Impact of Low Interest Rates
Nearly everyone welcomes low interest rates with open arms. However, that doesn’t mean everyone will feel a positive impact. Let’s look at some things that you should be wary of.
The Nation has had an eventful year to date, and it certainly hasn’t been all quiet on the economy front.
The Reserve Bank of Australia (RBA) ended 2019 with an interest rate reduction to 0.75%. In an attempt to stimulate the economy, the RBA has reduced rates twice in 2020 to a low of 0.25%. RBA hopes that the cash rate reduction will be the necessary trigger for a U-turn.
The move is hoping to relieve the purse strings of Australians, releasing a little pressure and hopefully a little cash reserves that will be spent at local businesses.
On paper, an interest rate reduction should help both companies and individuals in many ways. However, this doesn’t mean that you shouldn’t take precautions. Especially because numbers and short-term upswings (if any) tend to mask the real picture.
With a recession looming, let’s take a look at the impact low interest rates have on both businesses and individuals. And after, we’ll deal with all of its potential negative impacts.
Why You May Like Low Interest Rates
A decrease in interest rates opens an array of possibilities. This is especially true if you know how to use it properly.
Here are some of the most common benefits that you can take advantage of:
1. It’s Easier to Make Loan Repayments
During a recession, a lot of large banks lose their ability to lend money due to a lack of capital. And even when they do, it’s with adverse repayment conditions.
When short-term interest rates are low, banks improve their capacity to lend money.
This works both ways. Low interest rates cause banks to “recapitalize” and lend more money. In return, they provide lenders with much better repayment conditions.
That way, lenders can easily repay money to the banks while banks essentially earn more money.
Businesses and investors may be enticed to take out loans – small business owners, huge companies, and regular consumers.
2. Your Assets May Increase in Value
Lower cash rates will impact the value of assets in many ways.
Depending on other market conditions, housing prices tend to increase as demand improves. Favourable bank loans and easier repayments make buying properties much more attractive.
Additionally, a spike in additional discretionary spending has an impact on higher employment and productivity. Therefore, even non-housing assets, such as products and services, and share prices as companies earn more, may increase as demand increases.
3. It Leads to Overall Economic Stimulation
Prolonged increased spending also has an impact on the consumer price index (CPI – the rate the cost of living is increasing or decreasing). During a period of economic stimulation, we may observe CPI heading north. Increasing the overall cost of living.
It sets off a chain reaction.
This stimulation of the economy should lead to a healthy financial ecosystem. However, it’s not always efficient in practice.
The Unexpected Negative Impacts
There’s one big issue with low interest rates:
They look far more attractive than they actually are.
If this move is dead-certain to miraculously save any economy, everyone would use it. But in truth, the situation is far more complex.
Low interest rates can positively impact the economy long-term, but they are only a short-term solution. If low rates stay in place for a longer time than necessary, they can do more harm than good.
A lot of people rush to take advantage of low rates without thinking of the consequences. They make risky investments and loans, or even indulge in compulsive spending. And this can lead to some unfavourable outcomes.
Here are some common issues that may arise while the rates are low.
1. The Liquidity Trap
Just because the government lowers interest rates doesn’t mean the economy will grow.
When the rates are low, people may invest in assets that won’t spur employment. This includes stock markets and loan repayments, for example. Not stimulating the economy at all.
This further reduces the cash flow and unemployment rates may remain or increase. Prices may start falling, wage increases reduce if they are present at all and the value of the currency may deflate.
That’s why people should know when to start saving or what’s the best asset to invest in. If you just go with the flow, you may end up falling into the same trap.
To avoid it, you need to have impeccable financial insight. However, it may be hard to predict such an outcome without a professional consultant.
2. Investors May (Wrongly) Invest Out of Their Comfort Zone
When the housing prices go up, but so do dividends and rents, the majority of investors don’t want to miss the opportunity, so they rush into buying these assets.
But there’s a big problem.
A lot of those who jump at the chance aren’t aware of the complexity of the market. Many investors go out of their comfort zone, even if they have no prior experience.
Because of this, they end up buying assets that potentially fluctuate more than they are comfortable with. Causing possible sleepless nights later on. Or buy property that was a little out of reach but now becomes affordable. And when interest rates rise again (and they always do) repayment create significant strain on the purse strings. If they don’t assess the long-term state of the economy and their own risk profile, they can create a lot of financial stress later on.
What if the economy tanks and it becomes impossible to rent out the property you bought?
That’s just one of many possible negative outcomes.
It’s vital to have a financial plan that stands the test of time and a financial planner to guide you through, empowering you to make well-informed financial decisions. No matter the market conditions.
3. The Turnaround Can Be Painful
The financial tides are constantly shifting.
But a period of low interest rates usually doesn’t last long. History has often witnessed sudden changes in the market. A few months or years of low interest rates could lead to a new period of increased austerity.
Your future depends on the choices that you make in the present. If you’re focusing on the current situation too much, you won’t be ready for what comes next.
There’s always a chance for the economy to fall into a liquidity trap. The inflation may get worse and you may experience various unexpected movements.
The key is to know what you’re doing.
Are you just hoping that everything will turn out well or do you understand the market?
If you have a strategic financial plan in place and expert advice on top of that, you’ll learn how to spot the opportunities.
Make Educated Guesses
Truth be told, a period of low interest rates is a good time to make some financial decisions. However, there’s a real chance that it may go wrong. The present situation shouldn’t trick you into thinking that every choice is a good choice.
Take your time to make a financial plan so you don’t regret any option that you take. Of course, it would be better if you mapped out your plan with an expert.
Our experts at Modoras have decades of experience in doing exactly that. We’ve helped hundreds of clients take correct financial choices and improve their lifestyle.
7 Steps to Financial Recovery Post-COVID
With the possibility of eased restrictions on the horizon, now is the best time to prepare for financial resilience post COVID.
Don’t wait for restrictions to ease to take action, that will be too late!
Join us for this interactive question and answer webinar where we will hear Modoras Melbourne Directors Ian Fox and Alf Couceiro, share the 7 critical steps to success coming out of lockdown.
If you want us to assess your profile and guide you through this low-interest-rate journey, contact us on 1300 888 803. Let’s make some good decisions and secure your financial future.
Want to know more?
- Holding Tight During Market Volatility
- Stop Investment Stress
- How does Global Inflation impact Australian Investors?
IMPORTANT INFORMATION: This blog has been prepared by Modoras Pty. Ltd. ABN 86 068 034 908 an Australian Financial Services and Credit Licences (Number 233209). The information and opinions contained in this presentation is general information only and is not intended to represent specific personal advice (Accounting, taxation, financial, insurance or credit). No individuals’ personal circumstances have been taken into consideration for the preparation of this material. Any individual making any investment or borrowing decisions should make their own assessment taking into account their own particular circumstances. The information and opinions herein do not constitute any recommendation to borrow funds or purchase, sell or hold any particular investment. Modoras Pty Ltd recommends that no financial product or financial service be acquired or disposed of, credit contract entered into or financial strategy adopted without you first obtaining professional personal financial advice suitable and appropriate to your own personal needs, objectives, goals and circumstances. Information, forecasts and opinions contained in this blog may change without notice. Modoras Pty. Ltd. does not guarantee the accuracy of the information at any particular time. Although care has been exercised in compiling the information contained within, Modoras Pty. Ltd. does not warrant that the articles within are free from errors, inaccuracies or omissions. To the extent permissible by law, neither Modoras Pty. Ltd. nor its employees, representatives or agents (including associated and affiliated companies) accept liability for loss or damages incurred as a result of a person acting in reliance of this publication.