6 Strategies for Mitigating Interest Rate Risk
When I first moved to Australia from the United States in 2003, I was amazed that there was no such thing here as a 30-year fixed rate mortgage. In the states, if you get suckered into a variable rate mortgage, you’re either financially illiterate, or you have really poor credit.
Here in Australia, we have no other option. You might be able to lock in a rate for five years, but you’ll pay for the privilege. And the banks aren’t stupid. They’ve priced their risks into fixed interest rates.
For the Australian investor, this brings a considerably greater degree of interest rate risk than the U.S. investor faces. In the states, the banks carry the interest rate risk.
The investor benefits by having a consistent monthly payment, which provides the ability to plan a long-term budget based on this fixed cost. In Australia, the investor carries the interest rate risk and must be prepared for future budget changes.
With interest rates at historically low rates, you would be wise to consider the impact of rising interest rates on your rental property portfolio. It’s possible that rates could continue to fall further in the next year. But eventually all financial variations tend to revert to a mean. In other words, over time, interest rates will tend to move toward their historical average.
The average standard variable home loan rate in Australia from 1990 to 2010 was 8.54 percent. That’s nearly double what some lenders are offering today. How would your cash flow situation change if your monthly interest expense doubled? Now is the time to begin to devise a strategy for dealing with interest rate risk.
Here are six strategies for mitigating interest rate risk in your rental property portfolio:
1. Know Your Crisis Point And Have An Action Plan.
As John F. Kennedy said, “The time to repair a roof is when the sun is shining.” Rather than waiting until you’re in the middle of crisis to devise a plan, work out now what your crisis point will be, and how you will respond.
You should know exactly what interest rate level would bring a personal financial crisis. In other words, if interest rates rose to this point, you would most likely need to sell your properties. If you know what that point is, you can begin to take action long before you reach your crisis point, and before most other investors are in the same situation.
2. Pay Back Principal Plus Interest.
I understand that this is contrary to the advice that most people receive.The common viewpoint is because property tends to increase in value over time, interest-only loans are beneficial, because they minimize your monthly mortgage costs and boost cash flow.
It all works out fine in the end, as long as your property doesn’t depreciate in value.
My frame of reference for what the future could hold is the United States and the change of property values investors have seen over the past decade. Back in 2006, investors were taking out interest-only loans with the same assumptions that we have here now.
Then, when their properties were worth less than they owed a few years later, they were stuck. Of course, Aussie investors come up with all of the reasons why it could never happen here, but who really knows?
Steve McKnight often says, “You get into debt to get out of debt.” Why not sacrifice cash flow and budget to begin paying off your mortgages gradually through a principal and interest loan? As you reduce your debt over time, you’ll also be reducing your exposure to interest rate risk.
3. Switch From Principal And Interest to Interest Only Loans in Emergencies Only.
If you’re already paying principal and interest loans and interest rates rise, you’ll have the option of switching to interest only loans to improve your cash flow and weather your financial storm. But if you were already on an interest only loan, your options are limited.
4. Maintain Sufficient Cash Reserves.
I have a close friend in the states who built a large portfolio of nearly 60 properties over just a few years. He maintained an emergency cash reserve of $50,000 and ended up draining the account twice due to cash flow problems. If he didn’t have his reserve, he would have been in deep financial trouble.
Holding cash reserves is always smart, and this is another way to prepare for interest rate rises in the future. That way, you’ll have the option of either paying down some of your debt, or you can use the funds to pay higher interest costs until you can reshuffle your assets.
5. Make Your Home Equity a No-go Zone.
If you use your personal residence as security against your investment loan and something does go awry, and you can’t pay your debts, the lender will come after your home.
One of the most important rules of risk management is, “Don’t risk more than you can afford to lose.” I’ve never met an investor who said they would be happy to lose their home in pursuit of their investment goals.
If that person does exist, I’m sure their spouse would feel differently.
6. Maintain a Long-term Perspective.
One ancient Hebrew proverb is worth considering here: “Wealth from get-rich-quick schemes quickly disappears; wealth from hard work grows over time.”
As investors, one of our greatest enemies is greed. Greed urges us to take uncalculated risks and try to grow our wealth too quickly. If we can maintain a long-term perspective, we can keep our greed in check and avoid putting ourselves in compromising financial situations.
Interest rate risk is only one facet of a complete investment risk strategy plan. Too often, investors focus on the moneymaking aspects of real estate investing, without properly considering the other side of the wealth creation coin – losing money.
Steve McKnight has written two complete sessions on “Identifying and Mitigating Investment Risk” in his Property Apprenticeship course. In these sessions, he delves deeper into where you should focus in your risk management plan.
He also offers some creative suggestions, along with a systematic plan for limiting your risk exposure. You can learn more about Steve’s training program options here.