Have your say: Why floating now looks permanently cheaper than fixed

By Bernard Hickey The instinctual reaction for home owners when interest rates start rising is to lock in for a long fixed term. The prospect of being hit with continual increases in a floating mortgage rate as the Reserve Bank of New Zealand progressively raises the Official Cash Rate (OCR) is too much for some to bear. That will still be the case for some people who simply want certainty in their household budgets. But choosing to fix rather than stay floating is no longer the automatically cheaper decision. The Reserve Bank's decision last week to leave the OCR on hold and suggest it will raise interest rates in the 'coming months' has confirmed that something fundamental has changed in the mortgage market and the economy. Governor Alan Bollard pointed out that he won't have to raise the OCR so far or so fast in this coming tightening cycle because of this fundamental change in the way banks fund their mortgages. During the housing boom from 2002 to 2007 banks were able to offer relatively cheap fixed rate mortgages because they could dive into the 'hot' wholesale money markets and raise money cheaply. Now these 'hot' money markets are much less welcoming and both the Reserve Bank and the banks themselves realise they need to wean themselves off this 'hot' money. They all got a fright during the worst of the Global Financial Crisis when these 'hot' markets froze, forcing the Reserve Bank and their Australian parents to tide them over with capital injections and special lending facilities. The Reserve Bank has formalised this push to get funding from more secure and longer term sources through its Core Funding Ratio (CFR), which specifies the banks had to fund 65% of their lending from secure and long term sources from April 1. This ratio will ratchet up to 75% within the next two years and will intensify the push by banks to compete for term deposits from 'mums and dads' and issue more expensive longer term bonds on international debt markets. This change in the way mortgages and other lending is funded is pushing up overall funding costs for banks. The Reserve Bank estimated the CFR would add around 10-20 basis points to funding costs. However, both the CFR and the banks' own push into more expensive funding has pushed up costs by around 100 to 150 basis points. KPMG have estimated a further 50 basis point increase over the next couple of years as the CFR rises to 75%. This has done two things. It has pushed up longer term fixed rates and lowered variable rates. This is known in the business as 'curve steepening'. Since April 30 last year, when the Reserve Bank cut the OCR to 2.5%, the average 2 year fixed mortgage rate has actually risen from 6.24% to 7.13%, Interest.co.nz data shows. Meanwhile the average floating rate mortgage has dropped from 6.34% to 5.86%. This is to pay for the average 1 year term deposit rate having risen from 4.39% to 5.05% over the same period. So floating rates are now consistently around 130 basis points cheaper than longer term fixed rates. This is encouraging many borrowers to switch to floating or to stay floating. KPMG estimates around 70% of new mortgages are floating, while the floating portion of the overall mortgage book has doubled to 30% in the last 3 years. The question for borrowers is whether this gap between floating and fixed will stay and whether it will be big enough to justify floating rather than fixing over the longer term. For example, someone buying a house now could take out a floating mortgage at 5.8% and that could rise to 8.5% by May 2012, given most economists are expecting the OCR to rise around 200-300 basis points. The other choice would be to take out a 2 year fixed rate of about 7.2% now. For most of that period the borrower would still better off on the variable rate and it would even out by the end. The problem though is that at the end the fixed rate borrower faces the choice of a new fixed rate at 9.7% or going back to the variable rate around 8.5%. Variable is just plain cheaper now. The next question is why won't the market go back to the 'normal' seen from 2002 to 2007? The simple answer is the crisis changed all that and the Reserve Bank is ensuring banks won't slip back into their easy, hot funding ways. Floating now appears the cheaper option than fixing for the longer term. * This article was first published in the Herald on Sunday. Your view? I welcome your thoughts, comments and challenges below.