As economists talk about rising interest rates for mortgages – probably around mid-2015 – it’s worth having a plan for repaying a home loan at a higher interest rate than the rate at which you borrowed. The risk here is pretty basic: you may have budgeted for monthly repayments of around $1700, but two years later the repayments are $2000. Now what?

The risk of defaulting on a mortgage, or going into arrears, is more evident when you consider that first-home buyers who bought a property in the past few years have never experienced rising interest rates. The last time the cash rate went up was in November 2010. research says that every 0.25 per cent rise on a $300,000 home loan costs an extra $50 a month in repayments; and in the current Reserve Bank survey, their expert panel predicts interest rates will increase 1.5 per cent in the next two to three years.

Whether you’ve recently bought your first home, or you plan to buy property this spring, here are some tips on avoiding the rising interest rate trap:

  • Understand that if interest rates rise by 1.5 per cent, it will add around $300 a month on a $300,000, 25-year loan, or around $600 per month for a $600,000 loan.
  • Be honest about your budget before you borrow. Lenders build a margin into your serviceability, allowing for rising interest rates. But those buffers are not credible if you have understated your monthly outgoings.
  • The “stress test” on a mortgage comes down to your household cash flow: if you’re looking for a loan, don’t “shop” to see what the mortgage providers will lend you – start with what you can afford. If you already have a variable rate loan, do your own stress test: write an honest household budget, and then – if you’ve borrowed at 5 per cent – run a scenario with rates at 7 per cent. Find where you are vulnerable.
  • Start an emergency fund and have a contingency plan in the event of you or your partner losing their job.
  • Prepare a plan by knowing the costs of closing-out an unaffordable loan and selling early if you have to.
  • Explore renting options. You can preserve your asset by renting-out the property and living in a cheaper rental, but will it work in your favour?
  • Know your refinancing options. Remember, once variable rates are rising, fixed rates are unlikely to be cheaper than variable; and if you refinance to a fixed rate now, you’ll still need a plan for when it reverts to a variable rate loan (at a higher rate).
  • Investigate a 100 per cent offset account – it could allow you to build an equity buffer before the rates rise.

The most important aspect for those who have never experienced rising interest rates is to acknowledge and talk about the scenario in advance. If in doubt, speak to a mortgage broker or financial adviser about strategies.

Rising interest rates are not necessarily a disaster – but ignoring them is a big mistake.

Read more:

Posted by Mark Bouris – The Age on 19th October, 2014