Warning of interest rate risks in property

During the week the International Monetary Fund joined the ranks of commentators concerned about housing property price booms resulting from easy credit and low interest rates.

The IMF's message was directed at financial institutions warning about the risks of allocating excessive amounts of their loan portfolios to buoyant property markets.

Australian financial institutions are concerned that this and similar concerns of the Reserve Bank may result in increased regulation of their business, including limits on their future lending for housing. Such re-regulation of the banking system may be considered, for example, if the Reserve Bank gives in to retail industry pressures to reduce rates further to boost Christmas spending.

The loan books of Australian banks are heavily allocated to residential property loans, which have been and continue to be seen especially after the global financial crisis as an easy and certain way to generate profits.

Apart from the possibility that higher prices will ultimately lead to increased levels of loan defaults if unemployment rises as expected, a major concern is that the banks rely heavily on overseas borrowings to fund a large percentage of their loans. This reliance on overseas funding could prove to be a risky strategy in the event of another financial crisis or decisions by overseas lenders to move funds to the US in response to higher rates there.

Also, over the past year there has been a resurgence of low deposit loans while credit assessments of borrowers are undertaken using only today's low interest rates as the cost involved. In reality, borrowing to purchase a home is a long-term decision with typical mortgages extending for up to 25 or 30 years.

Today's interest rates are thus not the only or main consideration for determining housing affordability. While predicting future movements in rates is an impossible exercise, the odds are high that some time in the future, they will be higher than they are now.

Borrowers have some flexibility to reduce their risks by taking out fixed rate loans for periods of one to five years. After that, borrowers are at the mercy of the markets.

Low interest rates make purchasing expensive properties easier but they do not guarantee that properties will maintain their value in the future. The risk is that future interest rate rises can result in an increased number of forced sales by over-committed borrowers.

The key message for purchasers contemplating joining the present rush to invest in property is to be certain that they can afford the commitment involved even if interest rates rise in the future.

Having the capacity to pay off loans quickly while rates remain low will also reduce the risks of buying in a strong market.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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