BRUCE WHITFIELD: What to do with your rate cut windfall
You should be using this as an opportunity to shore up your financial defences, rather than behaving like you’ve won the lottery
The world really has gone mad. Not only has SA Reserve Bank governor Lesetja Kganyago now implemented a second 100 basis point interest rate cut within a month, he did so in shirt sleeves, from home, over the Internet, after announcing the fact on social media first.
At the risk of using this month’s most overused word, it’s, well, unprecedented. And the way you treat the resulting cash windfall also needs to be different.
Cutting interest rates is designed to boost consumer confidence and encourage spending. Now, however, it’s become an economic survival strategy.
Economics textbooks will tell you that cutting rates leads to growth. It has certainly worked like clockwork in the past. When economies overheat, and spending threatens to push up inflation, central banks remove money from the system by raising rates again. That gives consumers less disposable income, which discourages spending and cools demand, and this, in turn, reduces inflationary pressure.
It’s part science, part art, and increasingly it’s also expected to achieve miracles.
The fact that the Bank is cutting rates as aggressively as it is should worry you, rather than excite you. Rather than doing what Kganyago wants you to do, which is spend it, you should use this time to get rid of debt. Fast.
Consumer demand has been strangled by the lockdown, oil prices are at multidecade lows and demand for goods and services are in recession. Inflation, even in SA, has beaten a hasty retreat, which has given the Bank scope to cut interest rates further, in the hope that it will alleviate some of the pressure on the economy and make it easier for banks to lend at more affordable rates.
This is why you should be using this as an opportunity to shore up your financial defences rather than behaving like you’ve won the lottery.
A case study in saving
Let’s assume, for the ease of illustration, that you have a R1m mortgage at the prime lending rate, over 20 years.
This time last year, with the prime lending rate at 10.25%, you were paying R9,816 a month to service that debt. Today, money is 24% cheaper than it was a year ago thanks to four interest rate cuts in the past 12 months. The first two 25 basis point cuts were barely noticeable, but the two 100-basis point cuts in less than a month mean that with the right approach this is a time to capitalise on cheaper money.
This week’s cut alone means you are going to be paying the bank R628 less per month in interest for every R1m you borrow over 20 years. Again, that’s the price of a decent meal out for two (remember those?). But when you look at the cumulative effect of the cuts, things become a lot more interesting.
Compared with this time last year, you will have to pay the bank R1,607 less in interest every month on that R1m loan. With the prime interest rate now at 7.75%, that R1m costs R8,209 a month – which gives you additional cash flow.
You can either treat yourself in the short term or save a whack of cash over time. What if you kept your bond repayment at the same level as last year? Instead of spending that money on upgrading your DStv package, shopping at Woolies rather than Shoprite or downloading more albums from iTunes, why not keep paying the bank the same as you were a year ago?
Doing that would reduce the duration of your mortgage term by nearly seven years. Interest payments on R1m over 20 years mean you need to pay R2.35m over the duration to service that debt. By paying the extra amount, you reduce the overall cost to R1.97m. While that might not seem significant, it’s a fact that you will pay off your debt in just over 13 years rather than the 20 you signed up for.
Building a moat
The policy actions being taken are indeed unprecedented and that means you need to be using the breaks you are given to build as many protections as you can.
The world is already in recession because about half the global population is in some kind of government-enforced lockdown. The International Monetary Fund (IMF) is predicting GDP contractions of about 7.5% in the eurozone, 6.5% in the UK and 5.9% in the US. The IMF’s expectations for SA are pretty much in line with those of the Bank, as it projects a 5.8% GDP decline this year versus the Armageddon-esque prediction of -10% of private sector business organisations.
It matters little who is right. It’s going to be rough regardless. And the best thing you can do right now is build a moat around your finances as governments around the world come under pressure to allow their citizens to get back to work.
The longer it takes, the bigger the risk there is to your financial wellbeing. How you protect your downside is up to you.
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