This blog post was originally posted back on April 18, 2012. I revisited the post today (October 2, 2012) as the reserve bank of Australia (RBA) lowered interest rates yet again and through 2013, rates keep falling!.

I was shocked to hear the treasurer claim that the reduction was as a direct result of the government’s good work. This is despite the RBA issuing a warning that the global economy is a concern and the mining boom in Australia is all but at an end. As a result, lowering interest rates is an opportunity to stimulate an economy that is not doing so well right now.

While many with a large mortgage will welcome the news, retirees who survive  off their bank deposits will have a growing concern as to how they will survive off their investments.

The bottom line hasn’t changed since the original article was posted. If you have any doubts, go and ask anyone working in retail. Sales are slow as the economy as a whole is a little fragile right now.

Don’t celebrate this latest interest rate deduction. Treat it as a warning and this time, a warning in writing from the RBA.

Original Blog Post – April 18, 2012

The interest rate debate in Australia is close to fever pitch. The media and business community are putting pressure on the Reserve Bank of Australia (RBA) to lower interest rates and this is (mostly) supported by the general public, but be warned –  lower interest rates is not always good news.

Interest rates can change for a variety of reasons and in Australia the key reason for lowering interest rates is due to a ‘slowing economy’. As the economy slows, economic growth becomes negligible. Reducing interest rates are designed to stimulate the economy by creating spare cash (more cash through reduced interest repayments) that can be spent on goods and services.

Lower interest rates in this environment should be seen as a warning, not a reason to go out and spend, because with a slower economy the following will be inevitable:

  • Personal income through overtime and bonuses will be reduced.
  • Job losses will occur
  • A slowing economy will mean less work opportunities

Reductions in interest rates is of course bad news for people relying on income to support themselves. For example, self and part funded retirees

The hidden traps of low interest rates

Low interest rates today are associated with low wage growth. If wages are stagnant this makes it very hard to get on top of your mortgage. In past years with strong wage growth it was much easier to more quickly pay down mortgages and other debts with extra repayments.

Low wage growth will also have a negative impact house prices and this is already being reflected in the housing market. Most areas have shown negative growth over the past 12 months. (Property Wire March 2012)

This means your equity (your share of the home after the mortgage) will be slow to improve.

The sting in the tail is that a small small reduction in house prices can have a large impact on your equity, as the bank always want their money back.

For example, If your home is worth $400,000 and you have a $300,000 mortgage, your equity is $100,000. If house prices drop by 10%, your home is now worth $360,000; but your equity has been reduced by 40%. Your equity has reduced $100,000 to $60,000 – Ouch!

 What should you do in this low interest rate/slow economic environment?

  • When you hear of rates falling, be careful – don’t go out an celebrate with a big new purchase
  • Always try and be ahead of your mortgage and other loan repayments
  • Aim to pay the debt with the largest interest rate first; this is normally the credit card debt
  • Search for the best interest rate not the best honeymoon rate. A small reduction in interest rates means a big difference in actual payments
  • Be conscious of the slowing economy. Be very aware of the job market and stay in touch with your key work connections.
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