Lessons on budgeting and interest rates from generations past

At the start of 2022 bond rates started to rise again. Signalling the end of ultra high returns on share markets and low interest rates. The same as it did earlier this year….and last year, the road ahead of us seems uncertain and maybe even a little bleak but we know it won’t last forever. In recent times many succumbed to FOMO and bought the big house or jumped into a share portfolio while they were at record highs. We know the old saying “the right time to invest is now” as, over time, most assets increase in value but it’s been so easy to forget this is not normal. As the Fed raises rates only 0.25% and the market reacts strongly, I think its time to talk about fundamentals.

The Sky didn’t fall for the generations before us.

Many of us have become accustomed to thinking in shorter time frames. Thinking more than a couple of weeks into the future seems difficult. Making a solid plan or bookings even 12 months away, have become a fantasy we are afraid to allow ourselves to commit to, after constant disappointments. The same can be said for looking back at history, with even a few years ago seeming like a far distant memory.

Since the global financial crisis in 2007 share markets have had a few blips, but have been generally very strong. Interest rates have been almost nil and it has been very easy to borrow money, further fuelling growth. For many, it would appear that this is normal, when in reality we have been living through a period of unparalleled growth. While the pandemic may have hampered our daily lives it surprisingly did very little to slow global growth as the demand for goods, services and real estate continued to rise.

A few years ago now I wrote a short whitepaper that was designed to help medical professionals understand the financial planning process and how it fits with their careers. The world is feeling a little more chaotic than usual right now. As we come out of the pandemic it’s hard not to look at rising costs of living, staff shortages and volatile share markets and think to ourselves that we are facing unprecedented times. Sure, there have been some significant events but the fundamentals at play are still the same as they have always been. We just need to be careful to remember that change is the only constant and although growth is slowing and storm clouds are building, we will be back in the green at some point.

What can we learn from history?

In the late 1980s (when we last saw inflation rise to todays levels) interest rates peaked at around 17%. Though its difficult to imagine that we might get back to these kind of levels I think its more reasonable to look a little more recent history we can see that a neutral rate sits around 7% as it did in circa 2007. Even with this weeks rate rise we are still at less than half of that at 2.9% . This weeks rate rise of 0.25% breaks trend with the now expected 0.50% rise, which indicates that rates rises are having the desired affect and growth is slowing but we still have a way to go.

In recent times, property prices have increased significantly, with a 10 fold increase since the 1980s. The 17% rates in 1980 would have been difficult for home owners to manage, but they applied to an average $70,000 mortgage rather than a $1,000,000 mortgage. Since then wages have obviously increased from around $15kpa to around $60kpa. So while average income has increased 400%, property prices have increased 1,000%. This disconnect alone is good reason for rates to stay at historically low levels for some time. Even though they are starting to drop, household savings are higher than they have been since the 1980s meaning we all have a greater cushion to deal with financial setbacks but this is not limitless.

Cool numbers, what does this mean for me?

To put this in context, if you purchased a home recently it’s likely you have a mortgage of at least $1mil. Your monthly payments on a loan like this will have increased by $1,520pm since the start of the year. Still a long way from the $14,257pm total that you might be facing if the extremes of the 1980s came about and rates ended up at 17%.

If, like a large majority of home owners, you have fixed all or part of your mortgage at sub 2% rates you likely won’t have noticed any dramatic change. When these fixed terms come to an end, and your interest switches to the current variable rate, it likely will be quite a shock financially. This will be amplified by a higher cost of living in a high inflation environment. Property markets in many areas have already started to drop, as supply increases due to investors or owners offloading property that they know they wont be able to afford with higher repayments. All these elements create an expensive environment for property owners. What is key is looking carefully at your finances to budget for the inevitable.

Time to budget!

Here at NOR are aware that budgeting can be considered a pretty dry subject. Understanding where your money is being spent and ensuring that your budget can handle higher repayments is key to being able to continue your lifestyle. A simple solution is to calculate your repayments based on your minimum repayment using a 7% interest rate. While that might be an overkill for now it’s very likely that rates will return to this level at some point over a 30 year mortgage so paying more off your principal now could be simply considered a tax free investment. Plus the more you pay off your principal earlier the easier it will be to adjust your borrowing later.

There are many resources available to help you understand your budget WeMoney is a good example but there are many others. The Barefoot investor has a widely recognised budget plan which I think is good in principal, but doesn’t work well for higher income or even higher debt households in this environment. Like much of Pape’s work, this is dated and oversimplified but as a simple guide this is still one of the best.

An ex Adviser Glen James took this even further with his spending plan which is part of his book Sort Your Money Out and Get Invested. We sent a few copies of this out last year and it has been well received.

Once you understand where your income flows to you will then be empowered to know where you might be able to make adjustments. Then you can start to anticipate changes that can be made both now and over set time frames. This is a foundation of goals based advice, knowing what you want to achieve and creating a realistic plan to make those goals happen.

Sanity check

One of the first things they taught me in Senior First Aid (my highest level of medical qualification, now expired) was to first check for danger. If you are rushing into anything, be it buying a home or investment property we advise you to stop and ask why. Will it make my life better in the short or even medium term? Am I worried that I might miss out on massive financial gains? Am I trying to keep up with the Jones’ and others on social media?

The majority of our clients are doctors in training with young families and this means A LOT of pressure - at work, sitting exams and financially. Are you ready to commit to $X per month over the next 30 years for an investment property or is this going to drain your savings and you will need to draw on it in just a few months and then feel guilty for it? Do you need the big house (with the big mortgage) or will you struggle with repayments and should wait until post fellowship?? Are you using reasonable assumptions on interest rates and costs to furnish and renovate your house?

One thing I can say for sure is that when doctors finish training programs they usually have a very significant increase in income and decrease in expense. They also have far more spare time to spend money! One of the traps this cohort can fall into is a feeling that they have been putting things off during the last couple of years of their training and need to “catch up”. This can lead to lots of big decisions made quickly - often involving moving house or investment property purchase.

Work through your options, understand your tolerances

Whether it be through a financial adviser, mortgage broker or trusted business colleague, you need to work through your options with someone. Start by getting your budget air tight and including tolerances for various things such as holidays and maternity leave etc etc. Once you have sorted out your budget, you can start to look at what you really want in terms of property investments and how much you are prepared to pay for them. That might be the million dollar house in the perfect area, or potentially a less expensive home as a stepping stone/investment property with an investment home so you can retire earlier. It’s very often not an all or nothing approach and property ownership should be considered as part of an overall healthy financial portfolio.

As always, this is not to be considered personalised financial advice that takes into account your unique needs and circumstances. This has been written for education purposes only.