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The Downside of Lower Interest Rates

Interest RatesThe Reserve Bank continues to be bearish on interest rates and many market commentators are forecasting a further reduction in the OCR (Official Cash Rate) from its already historically low level of 2.00%.

It was over 8% as recently as July 2008. So, in eight years we have seen more than a 75% reduction in the OCR.

This has been good news for mortgage borrowers with One Year Fixed Rates under 5% at the big 5 lenders (ASB, ANZ, BNZ, KiwiBank, Westpac) and Floating Rates all around 5.5%.

These low interest rates have certainly helped fuel an already desperate property market in Auckland driven by high demand and low supply. The effects of which have spread to other areas in New Zealand - Bay of Plenty and Waikato to name but two.

However, approximately a third of the 1.2 million private dwellings in New Zealand are owner occupied and without a mortgage. These people don't benefit from lower interest rates and indeed may become victim to them. Many are retired folk who are living off their nest egg.

Where they were enjoying term deposit rates of over 9% p.a. just 8 years ago they are now having to settle for 3% p.a. and if they have money on call it could be as low as 1% p.a.. When you factor in tax due on this interest the amount to live on has reduced sharply and many are having to eat into capital or look for higher investment returns.

This has led to many buying investment property (residential or commercial). While to date they have seen stellar returns of a capital nature the actual rental returns are now becoming difficult to justify.

We have seen the return of syndicated property. Some of these offerings have projected returns of under 8% and with very poor liquidity.

Many New Zealanders adopt the outlook "one bitten, twice shy". And, as a consequence of the 1987 share market crash many still hold a negative view of direct equity investment. Also, the collapse of so many finance companies in the last 10 years has led to the demise of this market segment from mainstream NZ.

Private Bankers and many financial advisors have in recent times diversified clients away from Term Deposits with a mixture of Managed Funds and Corporate Bonds to provide higher returns. However, these services don't come cheap and with managed funds on average producing between 3-5% p.a. for the past 12 months, then custodial fees or monitoring fees of over 1% p.a. (in addition to the fund manager fees) are eating into client returns.

In a world that has become more complex sometimes simplicity is the best answer. Simplicity also allows for a Do-It-Yourself approach. In recent times I have seen a number of people adopt strategies to provide a regular return using a range of tools.

  1. Direct Share Ownership. The New Zealand Sharemarket is far removed from the froth and little substance of the 1980's. We have a range of companies that fit into the description "Defensive Stocks" that don't necessarily have high price movements but the value is in the stable long term earnings. Among these companies are utility companies including electricity suppliers, telecommunication companies and banks. A mix of such companies would provide an annual gross dividend yield in excess of 6%. (Twice that of a one year term deposit). There is also greater liquidity with stocks traded daily.
  2. In-Family Mortgage - I have seen situations where instead of taking a mortgage from a bank a young couple have instead borrowed on the same terms from retired family members. This has given the borrowers a source of funds without recourse to the bank and the lenders have again achieved a greater return than a term deposit. For this to work it does need to be set up on the same commercial terms as would apply if dealing with a bank. This scenario is not a case of lender of last resort - it is to provide positive benefits to both parties. Of course, if a bank wouldn't approve the loan, neither should the family member.
  3. Given some bank accounts are paying between 0% and 1% per annum interest having some money in Bonus Bonds is a cheaper form of Lotto. There is a monthly prize of $1,000,000 and unlike Lotto you at least can choose when you get your money back. While you may not win the first prize there are many smaller monthly prizes and it is not inconceivable to win more than 1% of your capital over the course of the year. All winnings are tax free.

These may not be everyone's cup of tea but I have seen all of them in practice.

There are two trains of thought in respect to debt in times of low interest rates. Some believe it is a good time to borrow and speculate to accumulate. We have seen some people do very well with this strategy in property in the last 5 years. Others believe it is a good time to increase repayments and make serious headway in reducing outstanding debt. The lower the interest rate the more impact each installment has on repaying the principal. This builds a buffer should interest rates start to rise or you get into a position through job loss, injury or illness that you can't meet your obligations for a short period of time.

Whichever your philosophy it is the right one for you if you can sleep at night. Financial stress is well worth avoiding as it is a major factor in everything from divorce to suicides.

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