Interest rates are low. Very low. And most people think this is a wonderful thing.
But do we understand why they have actually fallen?
Well, in short, when the Federal Reserve Bank reduces interest rates, they are ultimately trying to create stimulus in the economy. The perception is, if it costs us less to borrow money then in theory we should have more of it to spend. Makes sense.
And they want you to spend this money on stuff. It keeps people employed, selling more products, creating more profit and more taxation revenue. The result is a stimulated economy.
What has actually happened in the last few years is falling interest rates usually correlate with bad investment market conditions. Nervousness and fear. Worry that they are losing their money. Punters typically become more conservative.
So instead of spending the money, they are using it as an opportunity to build up extra savings. It costs less to borrow and when interest rates drop, so do monthly repayments resulting in an excess funds available.
The bank usually sends you a letter saying you can reduce your monthly repayments but the borrower decides to leave this on the higher rate therefore building more equity in the home.
Sound like a good strategy? For most people – yes.
It builds equity in the home as we are are already conditioned for the the monthly cash flow on the repayments.
But the question is, could you do something better with the surplus money?
Some other options might include:
The reality is there are lots of things you can do with it. And there is no simple answer to this.
Say your mortgage interest rate is at 4.5%. The question we should be asking is, if we are to invest any surplus funds anywhere else, where are we going to potentially earn a greater return of 4.5%?
Other factors also need to be taken into account such as tax, risk and opportunity cost.
Will these other investment options have a direct impact on the behavioral modification we may need to make when interest rates do go back up again? Now we are used to spending the money for something else that we weren’t paying for previously.
The worst case scenario is when someone keeps their mortgage repayments at the same level, builds some equity in the home, and then at some point withdraws it from the home loan and spends it on a holiday (just because they can).
So does the fact that interest rates have reduced mean we need to change the intent of what we want to do with our money? It is matter of having a conscious plan. Ensuring you dictate the terms to how we manage our money (and not the other way around).
If you need help formulating a plan and defining your intent, talk to Rothgard today.
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