Scared To Death Of Another Interest Rate Rise

In May of 2008 a friend called me up wanting advice on a home he and his partner wanted to purchase. The home he was looking at was $465,000. However he would only owe $435,000 after he had paid his deposit and got the government’s first home buyers’ grant. He was offered a variable home loan with one of the big banks at the then low interest rate of 5.33%.

So I started by asking him some questions as follows: His answers are in red.

What do you and you partner earn each week after tax? He said that they both took home just over $600.00 a week after tax. So total they earned was $1200 a week.

Do you expect to have children any time soon? No, none planned.

Do you have any other debt? $8000 on a credit card at 18% per cent interest.

How much money will you have in the bank after you purchase the house? Around $1500.

Do you have any other assets that can be sold quickly (e.g. shares)? Around $1000.

After some quick calculations I could see that his weekly payment on the home loan at 5.33% would be $605. This is a total of 50.41% of his take home wage. Meaning 0.50 cents in the dollar would go straight out the door in home loan payments.

If you refer back to my book, you will see in chapter 8 (How to pay so much money off your house that is sends shivers down your bank manager’s spine) the rule with home loans is to never go above 33% of your after tax pay.

So right away my advice was that they couldn’t afford this house. I knew this for four main reasons:

1.       It was above 33% of their nett after tax pay (well above)

2.       If you included their monthly credit card payment, their home loan and credit card payments would become 53.66% of their after tax pay.

3.       Interest rates were the lowest they have been in years. There is always a big possibility that they could jump up again.

4.       They had no assets of any great value. If one of them lost their job they would be in trouble very quickly.

To my calculations, he could afford a home $274,000 before deposit and first home buyers’ grant and $244,000 nett price after. Plus they could only afford this after they paid off their credit card in full.

Well you probably can guess what happened. He and his partner fell head over heels for the house they wanted and because the bank would lend them the money, they purchased it.

Now let’s fast forward to Jan 2010, only nine short months since they purchased the house. He has since called me in a panic about money. His problems are as follows.

Interest rates are now on the rise and have hit 6.08%. He and his partner are now paying $651 a week in payments... up $46 a week or $184 a month. This means their total weekly percentage of weekly wage to the home loan and credit card is 57.5% up from 53.66%.

When they moved in they took out a $10,000 personal loan to redo the garden. The bank that sold them the home loan suggested they could get it. This loan is over 3 years at 8.5%. This makes their weekly payments an extra $72.67. This makes their total nett percentage of paying back their home loan, credit card and personal loan up from 57.5% to 63.5%. So what that means is for every dollar they earn after tax (take home) $0.63 is going back out to pay debt.

This is before they pay for shopping, electricity, gas, car costs; insurance (the list is endless).

Can you see how their finances have taken a really hard hit?

To make matters more complicated, in Dec 2009 they found out that they are expecting their first child. This brings up new questions and problems. Will one of the parents stop working or go to part time? How will this impact on their spending? How will they pay for the expensive things to go in the nursery before the baby is born (cot, pram and change table)?

If one parent has to give up work, they will have to pay $762 a week in debt payments on a nett salary of $600.  This is 127% of their nett after tax wages just to pay for the debt alone. This is impossible!!!

Let’s put the baby aside for a second. Let’s say that over 2010; interest rates on their home loan went up by a further 1% to 7.08% p.a. Now the weekly payments on their $435,000 loan would be $714, plus the $39 for the credit card and the $72 for the personal loan. They would now have to pay $825 each week. Or to put it another way, 68.75% of their nett after tax pay would go to debt payments.

If it went up a further 1% to 8.08% they would owe $779 on their home loan or a total of $890 a week on all their debts. This is a total of 74.16% of their take home after tax pay.

Can you see why my advice is not to go over 33% of your take home pay for your home loan? My friend is scared to death. He has cut back his expenses everywhere he can. However he is just scaping by. And if interest rates do go up again, he says he will have to sell his house.

My friend had very real problems before they found out they were expecting. Now his problems are magnified.

Please, please, please anyone reading this do your sums if buying a house. Also if you live in a house, do your sums to see if it is too expensive for you. Just 20 to 30 minutes of doing your homework could save you headaches in the future.

Do not fall in love with a house or a suburb. You might find that you have to sell only a few years later, due to a lack of money.