What about borrowing money?

How do rising interest rates impact borrowers?

- The Official Cash Rate… It’s true that interest rates are rising, they’ve gone up already and they will continue to rise. You can’t turn on the news these days without hearing talk about the stock market, the economy, and “these high interest rates”. The official Cash r ate in Australia as I write is this is 2.35%, in New Zealand it’s 3.00%. Objectively, neither of these are ‘high’. They’re also only a fraction of the cost of funds for any borrower, as financiers build in credit risk, operational costs, and of course profit margins.

In fact, the rates most businesses pay for loans are far more influenced by the risk assessment that applies to them specifically, to their industry, and to the nature of their transaction. This isn’t to say that the cost of borrowing isn’t going up, but metrics like the Official Cash rate should be considered in context.

- Lock in your borrowing power… As interest rates rise the amount that a customer can borrow will often reduce. This is because most lenders look at historical earnings only, and then consider how much you could repay if your earnings stayed the same. To make matters worse, if you’re not looking at fixed rate funding the lender will build in a buffer in case payments need to be increased. In times of rising interest rates that buffer gets bigger, and your borrowing power goes down. In short if you’re confident in your business opportunity, it may not pay to wait to seek a finance approval.

- How inflation can help… A significant amount of business lending (particularly for terms of five years or less) is done on fixed rates. That means your payments never change for the term of the loan even if interest rates increase. This fixed rate funding becomes really important when you consider the impact of inflation…Consider ‘normal’ inflation is say 3%, and we’re a company selling cups of coffee. Our coffee shop takes out a loan with fixed repayments of $200 per week over 5 years. We sell coffee at $4.00 a cup today, but we put our prices up in-line with inflation (3% every year). By the time we get to the last year of our loan we’re selling coffee for $4.50 per cup, but our loan repayments are still fixed at $200 per week. If inflation is higher we will put our prices up more but our fixed rate loan repayments stay the same, a hedge against inflation.

What will bring inflation (and interest rates) under control?

If anyone had a definitive answer to this question world leaders would be beating a path to their door, but broadly we can expect inflation will return to ‘normal’ when supply and demand come back into alignment. An overall increase in economic activity can also bring inflation down, but there’s little doubt that much of the sharp inflation we’re seeing now is caused by a range of chronic supply issues in the face of sustained high demand. It’s easy to blame Covid, or russia, or floods, or El Nino, but ultimately, there is no one thing causing high inflation, and it’s no one thing that will bring it back down again.

ok, so what do we do?

I’m sure many of you have heard the trope about the Chinese symbol for crisis being a combination of the symbols for ‘danger’ and the symbol for ‘opportunity’ (that isn’t exactly true, but it’s still a good story). What is true is that in times of high inflation sitting on cash is a bad strategy, money sitting in the bank reduces in purchasing power fast, and very few savings accounts will provide anywhere near the level of returns that can be achieved through sound investment. For most investors times of high inflation means it’s the time to deploy cash and ensure that it’s invested in where it can grow in dollar terms with the market rather than risk being left behind. As a final thought, it’s important to remember that inflation is actually normal (much as some news outlets might try to make us believe otherwise, remember bad news sells best). Zero inflation is an abnormality in our economic system (Official Cash rates of nearly zero aren’t normal either). In mid-1985 base interest rates were about 16% and going to see Top Gun at the movies would set you back around $5. Here we are some 35+ years later, movie tickets still seem a bit steep to me (and don’t get me started on the price of pop-corn) but I’ll still be in the middle of the theatre watching Tom Cruise’s latest fighter jet masterpiece, doing Mach 2 with what’s left of my hair on fire, and happy enough to pay the price… inflation be damned.