Are we all doomed if interest rates rise?

Since Tuesday’s RBA decision to keep rates on hold, we have heard that the Australian economy has grown quite strongly over the first quarter of 2015.

Strong economic growth, if sustained, could lead to an increase in rates. However, the ASX futures market, armed with these positive economic growth numbers, are still predicting stable interest rates for a while to come (see below).

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What I find disappointing is the almost universal belief (in the media) that borrowers will be in deep trouble if interest rates begin to rise.

I have a contrary view. Although there will always be individual circumstances where people unfortunately find themselves in mortgage stress, the majority of borrowers are prepared to handle a modest increase in interest rates. This view is based on two key points:

1. When banks assess a borrower’s ability to repay a loan they use a “test” interest rate that is almost always above 7.00% p.a..

This means that most variable rates would have to increase by around 2.50% before borrowers are likely to struggle. In fact, some lenders assess repayment capacity at 8.00% p.a., which is nearly double the current interest rate.

2. The average monthly variable interest rate over the last 10 years is approximately 6.71% p.a. (see below). So the “test” rate is approximately 0.30% p.a. above the long term variable interest rate.

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As you can see, our banks have and are adopting quite conservative lending practices. Australian banks are arguably some of the most prudent financial institutions in the world. This conservative lending approach underpins the current price growth that we are seeing in some of our Capital cities. Far from contributing to house price growth, I feel that current lending policy is keeping a lid on the market.

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