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Brother in law’s guide: Why fudging the fixed vs floating decision makes sense
November 9th, 2009
By Bernard Hickey
Here’s the short version: Fixed mortgage rates are rising, but it’s possible variable mortgage rates could stay below fixed rates until late next year. Those choosing to go fully fixed for a 2 or 3 year term are betting the OCR will rise quickly above 5% by the end of next year from 2.5% now. That is possible if the economy recovers as strongly as most economists expect and given it has averaged 6% since 1999.
Those choosing to go completely variable are betting the OCR will stay below 5% until at least late next year, which is possible if the global economy remains stagnant and New Zealand’s economy recovers fitfully. I’d say to my ‘brother in law’ the safest bet right now is to split the mortgage into half variable and half 2 year fixed to allow early repayment and to reduce the risks of either a sudden move up in the OCR or no move at all.
Here’s the long version below
Every Monday from now on I’m going to review the various mortgage rates on offer and examine the types of decisions any homeowner has to make.
Every homeowner is different with different income situations and different needs for certainty. Some may want to take a punt on interest rates, while others are simply looking for the cheapest deal right now, or both. So I’ll look at one ‘type’ of home owner and any reader can make up their own mind whether this applies to them.
I’m going to call this type my ‘brother in law’. This home owner is living in the home, has a couple of young kids, one and a half incomes, and a desire to keep interest costs as low and as predictable as possible, while at the same time retaining some flexibility for debt repayment from bonuses, payouts and inheritances.
Where will interest rates go?
The first decision any home owner has to make before deciding what type of mortgage, what bank and what rate they want is what they think will happen to interest rates. Fixed mortgage rates are determined by what happens in wholesale interest rate markets, what happens in retail deposit rate markets and how much profit banks want to make. That’s plenty of variables right there, but unfortunately for punters there’s plenty more variance underneath that.
For example, wholesale interest rates are effectively the market’s judgement on where the Official Cash Rate (OCR) will be at a certain period in the future. The OCR, in turn, is decided by the Reserve Bank of New Zealand Governor Alan Bollard. His role is to keep the inflation outlook between 1 and 3% over the medium term. So traders and economists in these wholesale markets try to second guess Bollard on what he’s thinking now about the growth and inflation outlook and what might happen in the future.
The global economic outlook also has to be thrown into the mix because that can affect the New Zealand economy and sometimes cheap foreign money can flow into our wholesale money markets and push rates down. Another variable is New Zealand’s sovereign credit rating. If it was downgraded our wholesale interest rates would rise.
The longer the fixed mortgage term, the more variables come into play. For example, the Reserve Bank announced in June that banks would have to raise more of their funds locally and more of it at longer terms. This effectively pushed up the funding costs for banks and they have passed that on in the form of higher fixed mortgage rates. Noone can be particularly sure either what the banks will want to do with their profit margins. They have been falling for the last couple of years. That may not last.
Fixed interest rates are rising, but floating rates may be hold for another 7 months
The OCR has been unchanged at a record low of 2.5% since April 30 and the Reserve Bank has pledged four times since then to keep the OCR at or below 2.5% until the second half of 2010. If the RBNZ sticks to its promise, that means the OCR, and therefore variable mortgage rates, are unlikely to rise until July 29 next year at the earliest, which is the first OCR announcement in the second half of 2010.
However, fixed mortgage rates have risen sharply in the last 7 months, particularly longer term fixed rates. In the past many homeowners and banks opted for 2 year fixed rates. The average bank 2 year rate has risen from around 5.9% in mid February to around 7% now, while 5 year fixed rates have risen from around 6.5% in mid-February to around 8.6% now.
Fixed mortgage rates have averaged around 8% over the long run in New Zealand, so anything below 8% would appear cheap, unless you believe New Zealand and the world is likely to face permanently lower interest rates for years to come.
We are now in an historically unusual position where floating and very short term mortgage rates are cheaper than longer term mortgage rates. In the past the ‘easy’ decision was to opt for a longer term rate. Now that decision is not so easy. Those people who want the ‘certainty’ of a fixed rate for a longer period will have to pay more for that certainty and will have to take a conscious decision to pay more in the expectation that variable rates will be higher than their fixed rate for a good chunk of the fixed period.
Currently the lowest mortgage rates are variable and around 5.8%, while the best 2 year fixed rates are around 7%. This means that anyone taking out a 2 year fixed rate is assuming that the variable rate will be higher for at least the last year of the two year term. That would imply an OCR of around 5% late in 2011. That is possible, but would imply quite fast increases in the OCR in late 2010 and early 2011. However, it shouldn’t be forgotten that the OCR has averaged 6% since its introduction in 1999.
Anyone making the decision about a 2 or 3 year mortgage right now is taking a decision that the OCR will rise quickly from mid 2010 and keep rising through 2011. Anyone deciding to stick solely with a variable rate is assuming the OCR will stay at or below 5% for the next two to three years. That is also possible, but less likely in my view.
I believe there is too much stimulus in both the global and local economies, which will force central banks to quickly tighten money policy from early next year, particularly in New Zealand where the housing market is bubbling again because of cheap interest rates. The risk to that view is if the global economy fails to recover quickly and stagnates.
There is another way
One way for my fictional ‘brother in law’ to have his cake and eat it is to split the mortgage.
My brother in law wants to repay his mortgage as fast as possible and understands that repayments now save much more over time than waiting until the end of a fixed term to repay, even if the interest rate is a bit cheaper. There is the possibility of bonuses or redundancy payouts or inheritances that he wants to use to pay off the mortgage quickly.
One option is to split the mortgage into a fixed portion and a floating portion. This reduces the risks of being caught horribly by either interest rates rising sharply over 5% or not moving at all. It also allows early repayment.
The rates now
BNZ has the lowest variable rate at 5.59% for its Total Money loan, while ANZ has a 5.69% simple variable rate (only for 80% or lower loans), ASB has a 5.75% regular variable rate, Kiwibank has a 5.79% standard rate and National has a 5.75% regular variable rate. Westpac has a 5.69% Choices Everyday variable rate and a 6.29% standard variable rate.
At the moment I would suggest my brother in law keeps half floating and half fixed for around 18 months to 2 years. That’s about as long as you can reliably think about the future of interest rates and the 18 month rates are looking reasonably good value at the moment. Kiwibank has the lowest 18 month rate at 6.29%, while National is at 6.45%, Westpac is at 6.59% and BNZ is at 6.69%. ANZ is at 6.69% and ASB is at 6.75%.
The absolute cheapest combination (although I suspect my brother in law would want to keep both mortgages with the same bank for ease of service) is for a BNZ Total Money variable mortgage with a Kiwibank 18 month rate. Kiwibank and National have the most competitive combinations, while BNZ and Westpac are next, with ASB bringing up the rear.
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November 9th, 2009 at 6:47 pm
A timely piece BH. Alot of my friends are coming off fixed term and unsure what to do.
Another option is to fix for 2 to 3 years and take a mortgage with ASB Bank (your sponsor). ASB allows you to knock of $10K lumps of your P & I mortgage.
Martin Hawes recommends you always take a fixed interest mortgage rate
Three and four year rates are still around 8%-8.5% and this is the long term average for NZ.
I see alot of people floating or half floating and then seeing inflation going through the roof + the economy bouncing back into life and Mr Bollard “turning the ship on a dime” by ramping up interest rates to control it all
November 9th, 2009 at 9:10 pm
5 years fixed at 5.99% was a good move back in Feb/March
November 9th, 2009 at 10:18 pm
Good advice Bernard.
My take on what is going on in the local economy is that all is not rosy – this being the case, any significant change in the OCR will upset what is already quite fragile.
I suspect the OCR will rise toward the end of next year, but tentatively and may coincide with some small tax cuts.
The Reserve Bank insisting the banks raise more of their funds locally and more of it at longer terms was a good move and certainly helped alleviate the pressure on an already over stimulated property market.
More mortgages on floating or short term fixed rates will enable the reserve bank to have a more immediate affect on the economy without significant changes to the OCR which is probably a good thing.
November 10th, 2009 at 7:17 am
@28_year_old: “I see alot of people floating or half floating and then seeing inflation going through the roof + the economy bouncing back into life and Mr Bollard “turning the ship on a dime” by ramping up interest rates to control it all”
IF the economy bounces back, yes indeed…however NZ isnt alone in this, this time its a massive global event and probably the worst since the 1930s.
First look at history, if you look at the 1930s it took a decade and massive Govn spending near the end (and no public consumerism) of WW2 to lift out…They also had cheap and abundant local oil and raw materials….we (as in globally) dont have that anymore. Fast forward to Japan in the 1990s and their lost decade (that is approaching 2 decades), yet the thing to notice is they were alone in their problems they could export to the rest of the world, to recover. Yet they didnt and this is a global event so the globe has no where to export to.
Look at today, we see the USA and EU following Japan’s banking a Mpolicy ie not fix the issues…zombie banks and over-inflated companies….with too much capacity and oil running at 4% of GDP…ie $80 a barrel…
So, you are putting forward one possible scenario, yes I can consider it viable, but out of three possibilities, ie stagflation, or a second great depression I would consider it the least likely of the three. So for me its likely that we will languish at low OCR for several years….I think inflation wont happen within 2 probably 5…..ie the OCR rises to say 8% is for me is an unlikely event…so Im floating and using the difference to pay down the mortgage…so 1) I have less interest, and 2) Im used to paying the 12~14% it might get to without financial worry….Im baking that cost into my budgeting…
What you can do is run a spreadsheet and guess at rates over 5 years and compare that with a fixed of 5 years….when I did so we would have to see an OCR or 10% within 3 for me to lose money over 5….ie its too late 5.99% for 5 years was a good deal, 8+% today I think is a poor choice, but thats after all your call.
regards
November 10th, 2009 at 7:29 am
On the split option I would not go 60/50
I would be estimating the max any inheritance or bonus would be, and add a little bit more for the floating.
So say a mortgage of 200k expect max bonus to be 20K make the floating 50K
If have a say 50 or 80% equity in the home (which any sensible Bro in law would have)…again do the same reduce the equity and add more to the floating so one in effect has an OD of 20 or 30K ..for emergencies or able to take advantage of opportunities that may come up
November 10th, 2009 at 7:33 am
Put all your loan on floating for now and as soon as you see floating rate starting to rise, then switch to fixed in lots for 2 or 3 years, say 20% for each rise, keeping a base 20% always on floating to have flexibility of repayment.
November 10th, 2009 at 9:15 am
@EMkay I’d (in fact I am) sitting and wathcing what Bollard says.
November 10th, 2009 at 10:10 am
Nice steven, hope your putting all your surplus of income into it, every extra dollar will save you a small fortune!
November 10th, 2009 at 10:19 am
As a rough approximation (especially early in the mortgage), you can take the arithmetic average of the rates over the duration to compare. So for example, a 2 year @7% rate is equivalent to a 1 year @ 6% plus the second year @8%. I think there’s a better than even chance 1 year rates will still be less than 8% at the end of next year, so I’d probably opt for the 12 month rate now.
Do the maths for the longer durations – you’d have to be expecting short rates to increase quite a lot at the end of next year to be fixing long-term.
November 10th, 2009 at 10:22 am
Bernards options are:
1)fix at 8% if you think the economy will recover next year and rates will go up.
2)float at 5.7% if you think the economy won’t recover and rates will stay low
3)or split 50/50 if you have absolutly no idea what is going to happen.
I beleive all the indicators are pointing to a economic recovery with higher inflation and interest rates, Commodity prices are going up all over the place diary food prices are increasing, so is timber, oil etc.. Central banks everywhere are continuing to pump billions of new money into the financial system. The odds are heavily stacked towards inflation and double digit interest rates but the safest option would be to float and payoff as much principle as possible to avoid getting into financial strife whatever the senario.
November 10th, 2009 at 10:24 am
@Barry P: Yes…paying down debt first seems to be the classical way to “save”…the only thing Im considering is 2% of Kiwisaver to get the $1000 matched by the Govn…but even then most Kiwisaver accounts seem to have been losing(?)…and if we go second dip I assume they will lose more….so Im hanging off for a bit…before I lock myself in for a year. I think the other thing is to stay liquid because things can change so fast as weve seen over the last year. So if I lose my job and have to move to another town or even country! and I have a fixed mortgage then Im into hefty penalties…if its floating no penalties…
regards
November 10th, 2009 at 10:58 am
Good points steven
I’m no economist but with all the quantative easeing/money printing surely inflation will rise and the OCR is written policy to keep inflation between 1-3%.
Also Fonterra increased payouts by $1 a kilo yesterday, that will inject $1 billion into the economy
Personally my rentals are fixed 6.5% for next 5 years
Regards
November 10th, 2009 at 1:16 pm
Bernard, I think it’s clear that Bollard won’t be putting rates up in a hurry. Anyone who’s considering fixing right now is stark raving bonkers. It made sense a few months ago, but not now.
November 10th, 2009 at 5:02 pm
@Kieren – option 1 fixing @ 8% (3 years) is worse than doing a 1 year fix at 6% followed by a 2 year @9%. And worse than 1 year @ 6%, then 1 year @ 8%, then 1 year @ 10%. Interest rates have to move quite a lot before we get beyond even that scenario…
The difference between float and 1 year fix is minimal so I think that is probably worthwhile.
November 10th, 2009 at 6:50 pm
Bernard, I think we may be the brother in law! You explained our situation exactly. It is great you have explained the mortgage interest in an easy to understand article. We are not all economists and financial wizards and sometimes the technical jargon of money is lost on me.
Thanks to the other people who contribute their views too to other topics on this web, it has been a real eye opener for me and it has helped explained a few of the missing pieces of information.
Thanks again.
November 10th, 2009 at 6:53 pm
you used to be able to split the mortgage up to part floating, part 1 year part 2….etc
Is that still possible? At least you would get an average.
Glad I paid my house off in the 1980’s
Back to Trademe to buy some more shiny precious metals:)
November 10th, 2009 at 10:12 pm
> I’m no economist but with all the quantative easeing/money printing surely inflation will > rise and the OCR is written policy to keep inflation between 1-3%.
I don’t believe the Aussie banks – who pretty much own us – have actually engaged in quan-ti-ta-tive easing over the recession so I don’t see that as a reason for inflation rising in the Australasian context.
> Personally my rentals are fixed 6.5% for next 5 years
I don’t think you’ll lose to much on that deal over the next 5 years but I think you would do better if you had most of yours floating b/c I tend to agree with Steven that there is no great economic growth period coming b/c this is global and no one is going to be able to trade out of it. We are seeing the loss of cheap energy occurring at the same time that the American economy is imploding on mountains of bad debt / credit. The situation we find ourselves in today is the new norm moving forward – it will be very volitile but there is no way that there will be any lasting and high growth like we have seen in the last 10 years.
November 20th, 2009 at 11:52 pm
Why is it that all this whether to fix or not fix is based on forecasts? What is the real data such as historical trends and maybe more importantly what the maths is in regard to floating and fixed. If you can get 5.59% on TM from BNZ then how much would the floating rate have to increase for you to be better off by having fixed all or part for 2 years or what have you? The BNZ also allow lump sum payments of 5% to be paid off at any time with no penalty just to add to discussion above. I think it is quite obvious that people should be on floating, there is no other real option. The savings you will get in the short term will off set any risk in the medium term. No fixed rate, even 2 years, seems to be prudent unless you think that a 10% floating rate is likely inside 18months. Even then it may be that long term forecasts at that time show decreasing inflation and OCR and so long term rates drop significantly like what has happened in the past year or two.