Time to stress test your finances

Interest rateMany households are already seeing the impact of rising interest rates on their budgets. With interest rates increasing 100 basis points over the last three years, the prime lending interest rate has risen from 8.5% to 9.5% since 2012.

To put that into perspective, for every R100 000 you borrow you would pay an extra R1 000 a year (R83 per month). If for example you have a bond of R500 000, then an interest rate increase from 8.5% to 9.5% would see you pay an extra R416 per month.

In July this year the Reserve Bank increased interest rates by a further 0.25%, and it’s expected that rates will rise further, as the weaker rand means higher prices on imported goods, which means higher inflation.

While technically we are now entering a rising interest-rate cycle, economists believe that we have also entered a recession. Higher interest rates could choke any chance of an economic recovery, so a fine balance has to be found between containing imported inflation while not curbing potential economic growth.

Financial adviser Craig Gradidge of Gradidge Mahura Investments believes this means that interest rates will climb but more slowly, with rates going up at intervals of 0.25% at each Monetary Policy Committee meeting.

This gives consumers a bit of breathing space to review their finances to understand the impact of future rates on their budgets.

The stress test

“One way to stress test your finances is to calculate the impact of the higher rates on your loan repayments,” says Gradidge, who has provided the following table and information to calculate the impact of higher rates on one’s finances. The table shows by how much your income would need to increase in order for you to afford the higher loan repayments. It looks at two factors: interest rate increases and interest payments as a percentage of income.

GMI-table

So someone with 65% of their income being used to service debt will need to get a 14% increase in their income in order to afford higher interest payments if rates increased by 3%.

“While a 1% increase in rates seems largely manageable, increases of 3% and more could be disastrous for many. Someone with a current debt burden of 80% of income will need their income to increase by almost a third in order to maintain their current financial position,” says Gradidge, who adds that since 1976 rates increased by an average of 5% when rates were increasing. In 1998 rates increased by 7% in a six-month period, resulting in financial distress and disaster for many.

If you are thinking of buying a home, make sure you have built these future rates into your affordability assessment.

The prime interest rate is the rate that the banks use to base the interest rate they charge their clients for loans, including car and home loans. This rate is in turn based on the repo rate – the interest rate set by the Reserve Bank through the Monetary Policy Committee (MPC).

Interest rates are the government’s way of controlling inflation and the economy to some extent. So when inflation starts to rise, the Reserve Bank increases interest rates so that people start to save more and borrow less. Remember that low interest rates are very negative for savers, especially pensioners, so a balance has to be found between the savers and the borrowers.

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