Would 0.5% break you?

Would an interest rate increase of 0.5% hurt you or break you? If not, then you’re better off than 25% of all property investors!

Saw some interest work out of the crew at Digital Finance Analytics. You see a lot of theorising in the media, but DFA are interesting because they’re actually out there asking investors and home owners what’s going on.

And that’s why their latest survey raises a few eyebrows.

They went and asked mortgage holders what kind of interest rate rises they could hack before they found themselves in “financial discomfort.”

The term “financial discomfort” is open to interpretation. Sometimes I have so much money in my wallet I end up sitting like the tower of Pisa when I have it in my back-pocket, but I’m pretty sure this isn’t what they mean.

But while more money is always better than less, it’s probably safe to assume that financial discomfort is unsustainable. You might be able to put up with it for a few months, but at some point down the track, you’re going to need to adjust your position.

And so the results are a little worrying.

Looking first at investors, these are the results. Up and down the Y-axis is the percent of total investors. Left to right across the X-axis is the interest rate rise needed to throw them into financial discomfort.

First up, over 25% investors say they don’t even need a rate rise. They’re already in financial discomfort. They can’t hack anything. It’s almost like they’re banking on rates coming down.

I feel sorry for these guys. I’ve been there. It sucks.

Add another 5% of investors at 0.5% and 1%, and almost a third of Australian property investors can’t hack a rate increase of just 1%.

This is worrying. We could see some more APRA regulations coming in – more guidelines from BIS – and we could get 1% just out of regulatory adjustments. We’re not even talking about the rate cycle. Just in regulatory rebalancing.

If you can’t handle a 1% rise in rates, in the current environment, you’re vulnerable.

Going further along, it says that 50% of investors would be in difficulties if rates rose by 3%. Given banks are supposed to be allowing for 2.5% in their lending criteria, this is interesting / befuddling / worrying.

That said, there is light at the end of the tunnel. About a third of investors could handle rate increases of 6% or more, without batting an eyelid.

This is where I sit in the spectrum. And it’s where you want to be sitting too.

Gearing is the engine of wealth creation. It’s the first rule of wealth through OPM – other people’s money. And I can’t think of any strategy that works that doesn’t use it.

But like any power-tool, it comes with its dangers. Used incorrectly, it does have the power to break you.

And my guess is that the folks in the bottom 25% don’t quite know what they’re doing. They’ve probably followed cut and paste strategies from the newspaper – if they even have a strategy at all.

And I wonder what share of this 25% are negatively geared..? All of them?

But before I hear any whinging about “greedy investors”, it’s worth looking at what the data for owner-occupiers says.

It’s not quite as bad, but it’s a similar story.

Here, about 13% of owner-occupiers would be in trouble if rates rose at all. More than a third of households would struggle with rate increase of 3%.

Almost half of owner-occupiers though are sorted, and can handle large rate increases. (The data is for mortgage holders only, and excludes people who own their home outright.)

This is the nature of the market we have. People have forgotten what rate rises look like, if they’ve ever seen them at all.

And so in a competitive market, with enduring shortages of housing, people stretch themselves to the limit. Give themselves a wafer thin buffer and hope that she’ll be right.

I would definitely not recommend this strategy.

And I’m not making rate hikes my central scenario. Rates are still likely to go lower before they go higher in my mind. But I’m aware that things can change.

And with cyclical rate hikes, you tend to see them coming. What’s more concerning is the rate hikes that come out of nowhere, and have nothing to do with how the economy is tracking.

The thing to remember is that our banks get a lot of their money off-shore. They borrow it from international markets, and then lend it to us.

And so the rates we pay are tied to what the rates on international capital markets are. And they can change depending on what’s going on in any one of 200+ countries.

So say you get some credit crisis somewhere – in Greece again, or in one of the smaller oil countries. Or maybe some banks lent too much to one of these mining companies that are now going to the wall.

You could think of any number of factors that could lead to a global credit crunch, that could lead to a spike in the cost of money on international capital markets, that could lead to a financially uncomfortable rise of just 0.5%.

You’ve got to give yourself some head room. Because once the crunch comes, it will be too late to adjust your position. People will find themselves selling into a market full of sellers. The exits can get jammed.

Again, it just reinforces the importance of working with proven strategies, and following the lead of people who know what they’re doing. I can give you a few names, just ask me.

But I am curious to hear what people think. Do these results sound about right? How much could you handle before things got “uncomfortable”?