Tag Archives | interest rates

The Big Squeeze

the-big-squeezeThe Big Squeeze

New Zealand’s rate of inflation continues to be low, even though our economy is growing. Lower petrol prices, cheaper airfares and computer equipment are some of the biggest contributors to low inflation and have reduced the impact of higher prices for housing-related goods and services. However, this is not necessarily cause to celebrate. The way in which people spend and save is very much influenced by the rate of inflation. Rapid increases in prices can cause people to spend now rather than later in order to buy cheaper. Saving becomes less attractive because the purchasing power of money declines over time. On the other hand, when prices are falling, spending is delayed in order to buy cheaper. The economy then slows down and prices can fall even further.

While high inflation is not desirable, neither is deflation (falling prices). The aim of the Reserve Bank is to keep inflation at about 2%; not too high and not too low. The principal tool for achieving this target is the Official Cash Rate (OCR), which in turn has an influence on the interest rates set by banks for deposits and lending. In theory, a lower OCR should mean lower deposit and lending rates for savers and borrowers. This in turn encourages spending and investment, leading to higher inflation. However, the OCR is only one of several factors that determine bank interest rates, so a change does not always achieve the Reserve Bank’s aim.

With inflation only just above zero, there is a danger we will head into deflation and the Reserve Bank is likely to continue to drop the OCR. If this translates into lower bank interest rates, savers will be caught in a big squeeze between falling interest rates and rising inflation. This is an uncomfortable place to be for retirees.

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The Bond Maturity Crunch

The Bond Maturity Crunch

In the months prior to the Global Financial Crisis fixed interest investors reveled in high interest rates offered by bank deposits, bonds and finance company debentures. Volatile equity markets were unattractive by comparison and money flowed out of managed funds and shares into what was perceived to be a safe, high yielding haven. Of course, the delight with finance company debentures soon turned to misery, but those who locked their money into long term bank deposits and bonds at that time have continued to enjoy high interest rates despite current market rates having fallen to historically low levels. Five years on, a crisis now looms for those investors. Many are retirees who depend on interest payments to supplement their pensions. Once these high-yielding bonds mature over the next year or two, funds will be reinvested at much lower rates, perhaps around half of what they are currently earning. The effect will be more pronounced for those investors who did not spread their maturities to prevent the crisis that results when all funds mature at a time when interest rates are low.

The options for investors coming out of high-yielding bonds are limited. Some investors with a high need for income are looking to equities with high dividend yields as an alternative to low-yielding fixed interest. This is a rational solution providing those investors don’t need access to their capital for some time. The reality is that when investment yields are low and your need for income is high, your standard of living can only be maintained if you are prepared to use up some of your capital. This is a sensible approach if investment capital is run down in a planned way with an eye on ensuring it will last until late in life. In the long term, yields will improve.

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Wriggle Room

Wriggle Room

One of the traps of borrowing money in a low interest rate environment is not leaving enough spare money, or ‘wriggle room’ in your budget to cope with an increase in interest rates. This is particularly important to consider when you are buying your first home, upgrading to a more expensive home, or increasing your mortgage to pay for a new car or overseas holiday. There are several ways you can protect yourself from the effects of future increases so you don’t run out of money.

 Plan for an increase

When you are looking to increase your borrowing, do your budget based on loan repayments at a higher rate of interest. You will be able to pay off your mortgage more quickly while interest rates are low, and you can choose to keep you repayments at the same level if interest rates rise.

Have access to spare funds

Don’t borrow up to the maximum of your borrowing capacity. If things don’t go according to plan, you will have the option of increasing your borrowing. Have some savings set aside, preferably in an account where the savings will offset your mortgage to keep your interest payments down. Alternatively, have a line of credit into which you can put your savings. This has the effect of reducing the interest you pay while still having access to your funds if necessary

Fix the interest rate

Fixing the rate on at least part of your mortgage will give you certainty about your repayments. You may or may not save on the amount of interest you pay, but at least you will not be caught out with an unexpected increase in loan repayments. Remember that if you need to break the fixed rate, for example by selling your house, you may be charged a penalty.

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