It is important to take note that this article was originally published on Pocketsmith.
Everyone holds their breath every time the central bank makes an announcement.
Here in Aotearoa New Zealand, the Reserve Bank of NZ (RBNZ) just recently announced an overnight cash rate (OCR) hike by 25 basis points to 5.5%, the highest it has been for the past 5 years. For those of you not from Aotearoa, the OCR is the equivalent of the Base Rate in the UK or Federal Reserve Rate in the USA.
Any hikes to the OCR results in an overall increase in interest rates faced by consumers (us regular folks) and businesses (those who employ us regular folks).
How did we get here? Why are central banks around the world hiking their interest rates? Let’s start with a quick economy lesson on Inflation:
Inflation – what’s the big deal?
Let’s have a quick flashback to 2020. Ah, good times. When the pandemic was a big scary unknown and huge swathes of the worldwide population was put into virtual quarantine. Businesses suffered. Companies could not pay their workers. The wheels of global economy stopped turning.
In the face of economic meltdown (which would have let to an election meltdown for the governments in power), many governments around the world initiated recovery support services (handouts, really). These recovery funds help businesses survive COVID, kept people in lockdown paid and helped halt the spread of COVID.
These are all GOOD things. You can’t really fault the governments of the time to do what they did. The alternative would to have let people die and suffer (which is never a great election look). However the flip side of this is that a lot of cash got pumped into the economy. A lot of that cash came from new currency produced by the central bank and from sovereign debt.
This put a lot of money into the economy. Businesses were literally getting money for doing nothing. By extension, their workers were also getting money for nothing. This creates an ‘oversupply’ of currency in the economy. When people have a lot of money, they spend it. There is more money in circulation which allows suppliers to raise their prices and consumers are willing and able to pay those prices. Which is how you get inflation.
Of course there are a lot of other factors affecting inflation, like impacted supply chains, tighter border regulations and more recently, the war in Ukraine. But from a local perspective – inflation is driven by government spending.
Interest rates… to the rescue?
Here’s where interest rates come in. Every central bank around the world has a blunt tool at their disposal. That blunt tool is the ability to hike up the interest rate of their country’s banking system. Arguably there are other ways to combat inflation, like higher taxes or cuts to public services. But those are harder to sell to the public. With interest rate hikes, the government can pass the buck to the central bank and wash their hands clean of the matter come election time. This is especially true in countries where the central bank is independent of the government (like in NZ).
How it works is simple. As interest rates go up, people borrow less money. This means less money circulating in the economy. For people that already have debt (like your average homeowner with a mortgage), more of their income goes towards servicing their debt interest (instead of circulating in the economy). On top of that, savings accounts and term deposits suddenly become attractive investments as banks increase the interest return rate. This further encourages people to save money instead of spending it.
With less money circulating in the economy, suppliers are forced to reduce their prices (or not increase them by THAT much) and inflation is beaten… for now. Inflation is an ever present factor. You can’t eliminate inflation without eliminating human consumption. Once inflation is down to a manageable level (3 to 4% according to the RBNZ), we can see interest rates fall again. And the cycle begins anew.
Ok, what can I do about rising interest rates?
Well, unless you’re the governor/chairperson of your country’s central bank. There isn’t much you CAN do about interest rates.
But, as a consumer with debt, here are some tips to deal with rising interest rates:
Fix your rates if you can!
Interest rates are going to remain static for the next half decade or so. If your fixed term loan is up for renewal, try to get it fixed at the lowest rate the bank can offer you. I can guarantee that the next time it comes up for renewal, the rates offered will be higher.
Avoid buy now, pay later schemes
Buy now pay later (BNPL) schemes have proliferated in the past few years. They create a false sense of financial security in allowing consumers to borrow money, interest free. On the face of it, they’re not too different from credit cards. However unlike credit cards, their ‘late payment fees’ aren’t governed by interest rates and can sometimes be higher than credit card interest. You are better off saving that money (or paying off your mortgage) instead of buying that pizza. Besides, if you’re spending money you don’t have, you’re just contributing to the inflation problem by adding more cash into the economy and encouraging suppliers to set higher prices!
Its time to start side-hustlin’
Think about starting a business, like a small one on the side. The upshot of this is that you can start claiming expenses against your income. Also, this shifts you from being a consumer to being a producer. Now you can set exorbitant prices under the guise of inflation! Hooray! From a tax perspective, business owners typically pay less taxes than your average wage earner. This is because you can claim more against your income as expenses. Furthermore, if you run your business through a company, the tax rate is usually less than the top tax rate for personal income (in NZ the company tax rate is 28% vs the highest personal tax bracket of 39%). Less taxes equals more opportunity to service your existing debts!
Keep track of your finances (if you haven’t already)
If you’re reading this, I assume that you’re a pretty financially savvy person who uses accounting software to manage their life. If you’re still on the fence about this, you should make the jump and use accounting software (like Pocketsmith) to keep track of your personal finances. The ability to monitor your expenses VS your income is extremely powerful. This allows you to plan your finances ahead, set aside money for emergencies and even put money away for investing purposes.
I’ve actually written about why you should use a home accounting software, you can find it here.
Investing in an era of high interest rates
Let’s say you’ve been diligent in managing your finances and have some money set aside for investing. Should you be investing right now? Well, it depends on what your financial goals are.
Financial independence and early retirement
Just keep chucking money at that mortgage, buddy. Every dollar paid against your mortgage is interest saved in the future. In a time when we’re looking at 7 to 8 percent mortgage interest rate, every dollar paid off in mortgage principal is equivalent to a guaranteed return of 7 to 8 percent per dollar in interest saved. Good luck finding an investment with a better return than that. The faster you pay off your mortgage, the faster you reduce your yearly outgoings. This is usually the first major milestone in the FIRE journey.
Building a stock portfolio
If you can’t (or won’t) pay off your mortgage early (you may have a fixed rate contract), you can still look at some options for diversifying your investments. Stock markets (as of the time this article is published) have turned bearish and there are plenty of good deals to be found. Search for companies with long-term track records of profitability, a good return on assets and healthy cash balances. Avoid over-geared and unprofitable companies (even if their stock prices have been high in the past). Share prices have fallen across the board and with some homework, you can find a good deal. Don’t expect to make any money in the next couple of years though, it’ll take some time for the global stock markets to rebound. So don’t go investing cash that you’re going to need in the next couple of years.
Buying (more?) properties
If you’re reading this, I would assume you already own the property you live in. Should you then be buying up investment properties? It depends. As a result of higher interest rates, there is lower demand for properties around the world. Lower demand means reduced prices. Reduced prices means that you can potentially get a good investment property at a low(ish) price. The flip side is that you’d have to take a new mortgage (or re-mortgage your home) and contend with the currently high interest rate. If you can generate rent return that covers your mortgage repayments AND you’re planning on holding for the long to medium term, go for it. If you’re looking to flip properties, now is a bad time to do so, as property prices are likely to be depressed for the next couple of years. This is all assuming that you can convince your bankers to lend you more money in the first place (good luck!).
Saving up for your first home
With property prices on a downward trend, the barriers to entry have reduced for first time home buyers. This means that you may be well positioned to buy your first property in the next few years. What you do depends on how much you’ve saved up. If you’re less than 80% of the way to getting a decent deposit (about 10% of average property prices in your area) I would suggest parking your savings in a term deposit or peer to peer lending platform (like Squirrel) for the next 12 to 24 months and earn some of that high interest income. If you’re more than 80% of the way there, start talking to your banker/mortgage broker and work out how much you can borrow and what your monthly instalments will look like now and within the next couple of years. Accounting software (again, like Pocketsmith) is a great tool for telling you how much you can afford to pay in monthly instalments. Ideally your repayments should be near or equivalent to whatever you can pay in rent, with a 20% uplift to compensate for higher interest rates in the future. If you can afford this, you’re good to go!
Are you ready for higher interest rates?
The first thing you can do is to review your family’s (or personal) financial situation. If you’ve been using a software like Pocketsmith, this is very easy to do. Don’t have Pocketsmith? Then you need to take stock of your income and outgoings manually.
If you have any expensive credit card debt, focus on paying that off first (or transfer the credit to a new credit card). Then have a chat with your banker on what your upcoming repayments will look like under the new interest rates.
Keep following good financial advice and be conservative with investments (so no crypto, please!) and you should get through this rough patch just fine!
Stay positive!