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Predicting interest rate movements is a bit of a national pastime and while this can be an obsession for some, they are well worth thinking about.

Most economists believe rates are unlikely to go much lower. While some are predicting small rises starting from the fourth quarter of this year, others believe it will take until the first quarter of 2016 for the Reserve Bank to raise rates from the current 2.5 per cent a year level.

The policy of keeping interest rates low encourages greater borrowing and spending. However, it’s often beneficial to do the opposite of what the herd does.

With rates that have been low for such a long time it’s easy to become desensitised to and complacent about debt.

During the past decade there has been a move away from principal and interest lending (which requires some repayment of principal with each monthly payment) to a predominance of “interest-only” loans.

The flexibility of these loans are attractive yet there’s often a risk that principal repayments are indefinitely deferred, with borrowers forgetting that making the monthly interest payment is getting them no closer to being debt-free.

Knowing that rates can’t stay low forever, one strategy is to lock in a fixed rate for a longer term, with some institutions now offering five-year fixed rates at less than 5 per cent a year. However, paying off debt is an even better approach.

While it may seem counterintuitive, it offers many benefits including inbuilt protection for when rates start to go up. Making additional principal repayments gives you greater ability to absorb the increasing cost of interest, as you can keep your repayments the same and have a lower proportion allocated to the principal (which will naturally absorb the higher interest costs).

This strategy will also give you a greater sense of control over your finances when interest rates inevitably begin to rise. Furthermore, cheap credit often fuels asset price expansion, and this is one of the reasons it’s currently difficult to find compelling value in either the equity or property markets.

Rather than borrowing more to buy over-valued assets, a better way to create equity in your current investments is to reduce debt. If your debt is mainly consumer debt (personal loans or credit cards) then avoiding the high cost of these types of lending products is a good idea at any time, however now is a better time than ever.

By reducing consumer debt you’ll be in a strong position to use your cash flow to buy well-priced assets as opportunities present.

Rates will not stay low forever, so take advantage now, reduce your debt and don’t acquire more.


Posted by Catherine Robson – Money Manager (Fairfax) on 20th August, 2014