Lower Interest Rates – the Good, the Bad, and the Ugly

There have been murmurings that the Reserve Bank is considering lowering official interest rates to help stimulate the economy. Lower interest rates are a double edge sword, good for borrowers, bad for savers. But there is also a lesser understood ugly side.

The good. For borrowers, any reduction in interest rates is a welcome relief. If interest rates are less then your regular repayment will be less for the same loan term, freeing up some cash to do something else with.

Smart borrowers will maintain their previous repayment levels so that they are able to pay off their loans faster.

The bad. For savers, any reduction in interest rates is bad news, especially for those relying on returns from Cash type investments for their income. If a retiree was receiving say 3% from their investments, then a drop of 0.25% actually equates to about an 8% drop in total income received.

If you consider just a few short years ago interest rates of 5% or more were available from term deposits, then income from cash has nearly halved in a short period of time.

Smart investors will diversify their portfolios so they don’t rely on one type of investment for their long-term income needs.

The ugly. Many conservative investors have a significant exposure to Bonds in their Superannuation or Allocated pensions. What is little understood is that Bonds are traded daily on money markets, and whilst they are a very conservative investment in the long term, their capital value can certainly vary greatly in the short term.

Bonds work differently to how you would first expect them to do. When interest rates go down, the capital value of Bonds go up, as traders put more value on older Bonds with higher interest rates attached. That’s why in recent years returns from Bonds have been so good, interest rates worldwide have been steadily decreasing as Governments try and stimulate their economies.

The opposite happens when interest rates go up, short term capital values of Bonds will go down as investors put lesser value on existing Bonds with lower interest rates attached.

With interest rates at historically low rates the day is getting closer that they again go up. This will catch many unwary conservative investors by surprise. Many will not expect to suffer a short term capital loss by investing in Bonds.

How will a change in interest rates affect you?