x Abu Dhabi, UAETuesday 16 January 2018

How to avoid the rate trap

Smart money is on a sudden rise in the cost of borrowing within two years. Homeowners basking in the financial glow of bargain mortgages would be wise to prepare for a sudden spike in payments that could take the shine off heir low-interest savings.

A London bus advertisement provides some good advice for UK homeowners as it passes by the Bank of England, which has held the base rate at 0.5 per cent for the past 18 months.
A London bus advertisement provides some good advice for UK homeowners as it passes by the Bank of England, which has held the base rate at 0.5 per cent for the past 18 months.

Low global interest rates have been a lifesaver for some people and a kick in the teeth for others. They have put money into the pockets of homeowners and helped to prevent countless distressed sales, but condemned savers to rock-bottom returns on their money. Whether you are a winner or loser, there is one important thing to remember: current low rates are not normal. In fact, they are deeply abnormal. When the Bank of England slashed base rates to 0.5 per cent in March last year, this was the lowest they had been in 316 years. Even more incredibly, they have been held at that level for 18 months.

Interest rates may not rise for several years, but when they do, they could rise very quickly indeed, particularly if all that central bank money printing ends in hyper-inflationary tears. So could you survive a rise in interest rates? Economists are split over whether the global economy, and in particular the West, is heading into a deflationary or inflationary spiral. The answer will have a major impact on interest rates.

Deflationistas fear Western countries risk a Japanese-style "lost decade" of falling prices, as governments and consumers embrace austerity, bankers stop lending and the recovery runs aground. If that happens, central bankers will hold interest rates down in a desperate bid to reverse the deflationary spiral. It's a frightening scenario, but at least your mortgage payments won't rise (although the value of your house and size of your salary might).

Inflationistas argue that rampant quantitative easing, rising prices of commodities such as food and oil, and the government temptation to inflate away eye-watering sovereign debts could send the spiral in the opposite direction. The truth is, nobody knows. But if you're making mortgage payments on a property, you should prepare yourself for the latter scenario. Many borrowers have become a little too comfortable with low interest rates, says Spencer Lodge, the regional director of PIC, a member of independent financial advisers deVere Group. They have been lulled into a false sense of security, and a sudden hike could hit them hard.

"People tend to spend what they earn and live to their means," Mr Lodge says. "If interest rates rise sharply, they may struggle to keep up with debt repayments. If they don't prepare, they could even lose their home." Homeowners with variable rate mortgages shouldn't squander their monthly windfall, but should use it to build their savings or knock down their debt. If they don't, they could pay a high price.

Many people argue there is no point in paying off their mortgage when borrowing rates are so low. "There is some logic in that, but you should still clear other debts, such as credit cards, while building up a cash buffer for the future," he says. If you're thinking of taking on more debt at today's low rates, do a little stress testing first. You might be able to afford the repayments now, but what if rates shot up?

The people most exposed to a rate rebound are those with variable mortgages on properties back home in the US, UK and Europe, where interest rates have been hammered down to record lows, says Alwyn Owens, a UAE-based adviser at Dubai Financial Advice. Mr Owens recently remortgaged his own UK property, switching to a variable rate tracker charging 2.99 per cent over base - or 3.49 per cent. He admits he is taking a calculated gamble, betting that rates will stay low for the next two or three years, but has done his sums carefully. If base rates climb to 5 per cent, pushing his mortgage up to 7.99 per cent, he can still service his monthly repayments.

With variable rates notably cheaper than fixed rates, most other borrowers are taking a similar gamble. That's fine if you have also done your sums carefully. The worst type of mortgage to take now is a two-year fixed rate, Mr Owens says. "You will pay a premium over a variable rate deal, but the term of your fix is likely to end just as interest rates start rising, giving you an immediate payment shock," he says.

If you want to fix, it may be wiser to lock yourself in for much longer, for five or even 10 years. In the UK, Yorkshire Building Society currently offers a market-leading 10-year fixed rate at 4.99 per cent, available up to 25 per cent of property value. That could prove a good deal if mortgage rates hit 7 per cent or 8 per cent after three or four years. Again, that's a gamble. If the deflationistas are right and rates stay low for years, you've lost. But at least you won't lose your property.

Another worry is that the cost of borrowing could rise even if base rates don't budge. Lender nervousness, the end of government mortgage stimulus packages and tougher rules on capital adequacy requirements for banks could push up lending costs. That could make it harder to find a cheaper mortgage when your existing deal expires, especially if you don't have much spare equity in your property (and if house prices fall further, so will your precious spare equity).

Rising interest rates pose less of a threat to those with mortgages in the UAE, says Damian Hitchen, the managing director of Gulf Lenders Network, a mortgage brokerage in Dubai. Rather than plunging during the credit crunch, local borrowing rates have stuck at about 7 per cent to 8 per cent. "The UAE financial system isn't that mature. Lenders mostly depend on deposits to fund their mortgages. Getting liquidity into the market is much more difficult than in the West, and this has kept interest rates higher," Mr Hitchen says.

The local mortgage market is becoming more competitive, with the best deals starting at about 6 per cent, but that is still relatively high. "The UAE dirham is pegged to the US dollar, so you would have expected local interest rates to fall in line with the US, but they didn't," he says. "My worry is that they might still rise when they start rising in the US." Mr Hitchen says UAE banks would do everything in their power to keep rates down and lending margins tight. "The banks have an existing portfolio of mortgages to worry about, and a big hike in interest rates could cause them major problems. This should offer local borrowers some protection."

Ashley Clark, a director and chartered financial planner at Needanadviser.com, a specialist cross-border and international financial planning and tax adviser, says at some point rapid rate rises will become inevitable. Without a sustained burst of inflation, Western governments will never be able to repay their debts. Even supposedly tough fiscal regimes have dabbled in the dark arts of inflating away debts.

"[The former] British prime minister Margaret Thatcher allowed inflation to stay high throughout the 1980s. In May 1980, it stood at 21.9 per cent, effectively devaluing government debt by more than one fifth in just a year and by September 1990, it was still at 10.9 per cent, with interest rates above 15 per cent. This dramatically reduced the size of UK debt, even before any repayments were made. This time, it won't be just the UK, but a global pattern."

It won't happen immediately, so you have time to prepare. Mr Clark expects interest rates to stay low in the short term, followed by dramatic increases in five to 10 years, as economies overheat. He says you should seize this opportunity to clear as much debt as you can and start preparing your portfolio for a shift into inflation-busting investments. "Cash and fixed-interest debt such as government bonds are the investments to avoid when rates start rising, although you might consider corporate bonds in the shorter run. Index-linked bonds, property and commercial property funds are good long-term hedges against rising prices, while stock markets will also grow artificially on the back of inflation, although you should plan your exit before the bubble bursts," Mr Clark says.

Countries won't raise their rates at the same pace, and this will affect the relative performance of their currencies, says Rebecca Hooton, a Dubai-based business development manager at currency transfer specialists the Global Currency Exchange Service. "When a country starts increasing interest rates, its currency will typically rise as well. This could lead to more substantial fluctuations between currencies, which would have a big impact on people transferring money between different countries."

In buoyant Australia, base rates have risen from 3 per cent in October 2009 to 4.5 per cent in May this year and its currency has followed suit. This has been fun for Australian expatriates transferring money to the UAE and agony for those sending it the other way. Conversely, the sliding value of the pound sterling has led to a bonanza for British expatriates sending their dirham earnings back home.

"We've seen huge currency movements in the last couple of years, and when central bankers start lifting rates, the volatility will return," Mr Hooton says. All this assumes the inflationistas are ultimately proved right, and rates are hiked to keep spiralling prices in check. If they're wrong, we could face rampant deflation instead, which would bring an entirely different set of worries. That might be worth preparing for as well.