Low interest rates can encourage us to spend more.
Low interest rates can encourage us to spend more. Contributed

The dark side of lower interest rates

TWO consecutive rate cuts from the Reserve Bank of Australia (RBA) have pushed interest rates into unexplored territory, with home loan rates now dipping below 3 per cent.

Reduce Home Loans has announced a variable rate of 2.89 per cent and Greater Bank has a 1-year fixed rate of 2.99 per cent.

Low rates are good news for borrowers. But there is a dark side to today's super-low interest rates. They can encourage us to load up with more debt, and that's a problem because Australia's household debt, relative to income, has been steadily rising for the past 30 years.

Back in the early 1990s our debt-to-income ratio was 70 per cent. Today it's closer to 190 per cent. This means that an average person earning $80,000 annually is spending close to $152,000.

The only way this can be done is by borrowing money - and low interest rates make it easier to borrow more. The catch is that in today's environment of low wages growth, it's not always so easy to get ahead with debt.

High levels of debt also leave us vulnerable to a slowing of the economy, particularly if the job market is affected. And there is no doubt that our economy is showing signs of cooling.

Another change we're seeing in household debt relates to "who” not "how much”. There is a growing tendency for older home owners to carry big levels of debt. It has become more common to have a mortgage at the time of retirement

To be fair, most household debt relates to home loans, and our homes should grow in value over time. Nonetheless, carrying large amounts of debt means paying solid interest charges over time - even when rates are low. That's money we could be investing elsewhere.

Today's wafer-thin rates provide a golden opportunity to get ahead with debt. It helps to have a long-term plan to clear the slate.

Making extra repayments on your mortgage is a simple way to clear the balance sooner and save a bundle on interest. Simply leaving your repayments at their pre-rate cut level can be a painless way to pay more off your mortgage.

If you don't want to lock cash away, a home loan offset account offers at-call access to spare cash while still whittling away the loan balance.

It also helps to avoid treating your home like an ATM. Topping up your mortgage to fund not-so-valuable purchases like an annual holiday just adds to the debt burden.

Paul Clitheroe is Chairman of InvestSMART, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.

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