Bernard Hickey looks at how to think about whether to fix or float and what bank economists are saying

Bernard Hickey looks at how to think about whether to fix or float and what bank economists are saying

By Bernard Hickey

The big question for any borrower when they see interest rates rising is whether to fix or to stay floating.

The answer depends on your outlook for interest rates and your personal situation. A combination of both floating and fixed may also work, particularly if you want to be able to be more flexible in how you pay off your mortgage. It may also make sense to fix short term rather rather than longer.

A flat-to-falling OCR makes floating more attractive, while a fast-rising OCR makes fixing and fixing for a longer time more attractive.

It all depends on whether actual interest rate increases are close to the forecast track laid out by the Reserve Bank and expected by the financial markets. That's because fixed mortgage rates are heavily based on the 'swap' rates in wholesale markets and those 'swap' rates are dependent on those market expectations for future interest rates.

If interest rates move as expected then there's often not as much benefit in fixing as you might think.

The main benefits come from the banks accepting a lower 'profit' margin on fixed mortgages than advertised floating mortgage rates. Sometimes a floating rate borrower can get a better deal than a fixed mortgage simply by directly challenging your bank or working with a broker to challenge the bank to offer a better floating deal than the advertised deal.

But there is a way to work out which deal is cheaper over the full term of a mortgage. Interest.co.nz has a calculator that allows you to compare the costs of fixed vs floating over the full term, remembering that often the floating rate is cheaper in the first few months than a fixed rate, but then more expensive later in the term.

It's the total benefit that's important over the term of the mortgage and also whether rates actually rise faster or slower than the expected track built into your fixed rate mortgage.

Here's a table that shows the benefits of moving a NZ$500,000 mortgage from a floating rate of 5.5% to the various fixed options, assuming different interest rate tracks. The gains indicated as a positive and the losses are negative. The middle track for the OCR is in line with market expectations.

OCR rate by end of 2016 One year fixed (5.9%) Two year fixed (6.3%)
OCR at 4.25% (low) - NZ$4,473 - NZ$4,379
OCR at 4.75% (middle) - NZ$120 - NZ$26
OCR at 5.3% (high) + NZ$4,618 + NZ$4,712

What bank economists say

Bank of New Zealand Chief Economist Tony Alexander argued in his April 24 weekly summary that he would look to fix most of a mortgage for three years.

The Reserve Bank fully met expectations this morning by following it's March 13 increase in the official cash rate with another 0.25% rise. The rate now sits at 3% on its way to perhaps 3.75% come the end of this year and something near 5% come the end of 2015. However there is considerable uncertainty surrounding the end-point of this rate rise period and how quickly we will get there given lack of data providing us insight into how newly sensitive people are to interest rates following the global financial crisis.

So this is a suck it and see exercise and people should not be at all surprised if we see some big shifts in market expectations for what our interest rates will do over the next couple of years. That uncertainty tells us clearly that there is value in establishing a mix of fixed and floating rate debt exposure. If you have some debt at floating rates and we all prove hugely sensitive to rates going up then they will not go far and you will benefit from that portion of your debt at least. If you have some debt at fixed rates of at least three years duration then should we do what we have done in the past and largely ignore the Reserve Bank for the first couple of years of rate rises then you will have some insulation against the heights which floating rates will go to.

Therefore if I were a borrower at the moment I would seek to place over 60% of my debt at a three year fixed rate.

ASB's Economists Nick Tuffley and Chris Tennent-Brown wrote in this April 29 Home Loan Rate Report they think the OCR is likely to peak around 4.5%, which is lower than the Reserve Bank is forecasting, and that rolling short term fixed rates are cheapest.

The RBNZ has lifted the OCR at two consecutive meetings, and another increase looks likely when the Bank meets again in June. Accordingly, floating mortgage rates and short-term fixed rates are likely lift again soon. If borrowers have not reviewed their situation already, now is definitely the time to give it some thought and look at strategies to manage higher borrowing costs over future years.

We stress that if the RBNZ hikes more aggressively than we expect (i.e. more hikes early on in the cycle), or lifts the OCR higher than 4.5%, then these shorter- term rates will lift more than we are forecasting, making this strategy more expensive than the longer-term rates on offer today.
By 2016 we would expect the variable rate to be around 8.25%, and fixed-term rates to be up around 8% too, rather than the 7-7.5% level we are currently forecasting. A key thought is that fixing for longer terms now does give extra insurance against stronger OCR increases than we are expecting. Depending on borrowers’ risk appetite, that insurance may be worth taking. In this vein, the cost of some certainty is not actually too high, based on current mortgage rates. This is perhaps easiest illustrated with another example: The current floating rate is 6%.
If the RBNZ lifts the OCR again in April, then say again in July (as we are forecasting), the floating rate will most likely lift to around 6.25% in April, then 6.5% soon after the subsequent hike in July. A borrower can fix a 2-year mortgage for a carded rate of 6.29% right now. In other words, a borrower can lock in now a rate that is in line with what we expect the floating rate to be very soon, and lower than what we expect floating rates to cost around the middle of this year.

Westpac's economists said in this April 28 weekly commentary said fixers should not wait and that six month to three year rates offered similar value.

Floating mortgage rates usually work out to be more expensive for borrowers than short-term fixed rates, such as the six month rate.

However, floating may still be the preferred option for those who require flexibility in their repayments. For those who are looking to fix, there is little to gain from waiting. Fixed rates are more likely to rise than fall over the next few months.

Among the standard fixed rates, anything from six months to three years appears to offer similar value. Three-year rates are higher, but this is a fair reflection of where we think shorter-term rates are going to go over the next few years.

Fixing for four or five years may result in higher interest payments over the life of the loan than opting for shorter-term fixed rates. However, these longer-term fixed rates may still be preferred by those who are willing to pay for certainty.

ANZ Economists said in their April Property Focus their analysis indicated a two year rate was most attractive.

With the exception of a higher floating rate and an extraordinarily attractive 2 year fixed rate for borrowers with 20 percent equity or more,

The attractiveness of the 2 year rate – which sits back where it was in December – makes it hard to look past for borrowers who can access it. However, high-LVR borrowers are likely to be attracted to 6-18 month tenors, where lending rates are closer to floating.

Outside the specials, we see limited value in fixing now that wholesale interest rates are pricing in rate hikes flagged by the Reserve Bank.

(Updated April 30 with the latest views from BNZ, Westpac and ANZ)

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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19 Comments

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Anyway, it is a zero-sum game.
 
Bank will always be the winner.

Do the numbers for the past ten years .
Assume a $400,000 mortgage
Assume you were fixed at 10% since 2004
Assume you floated for the same period
Do the calculation and then decide  
Theres not much in it either way

That may be true Boatman, but the problem for some is that to achieve that average rate over the term, you've got to get the low, and to get the low you've got to have survived the high - for many of the over leveraged, that ain't necessarily an option. No one truly knows where rates might go over any cycle, especially this one, and especially one or two on here who were citing two rate cuts less than a year ago, and still offering "advice" and scorn of others.

I have stated often enough that the trend for interest rates is down, and will remain so. I went further at the start of the year and predicted any rises in the OCR would be short lived. They may see the year out, but they won't see 2015 out. Lets see who really understands interest eh?
 
Btw I would be interested in what your comment on what Aristotle said, that interest is immoral(unclean was the word he used, a term we could apply to anyone in finance)
 

Agree the medium term trend for rates is down. 
You may be proven right.
Look what happened in 2010   -   scorching of the green shoots before they appeared!
Usury?   Perhaps, a necessary evil.
If we all pooled our money & could be trusted, we could probably lend to each other at 0% or close.
 
 

I don't know about necessary. Tolerated through ignorance perhaps. Interest has only ever been levied when it was possible, because it requires growth. Constrain the growth and the bust will follow at a rate greater than the leverage and interest rates that took advantage of it.

Sorry scarfie I wasn't thinking of you as one of them but may have missed it. My problem is with people being convinced of a direction in rates, and completedly not understanding what risk management is about. Its not about direction its about risk management when you fix rates. No one, absolutely no one, knows where rates are going to go over a reasonable period of time, and someone stating that you shouldn't fix any risk without knowing the individual's vunerablities to rising rates is doing them a disservice. Far too many here seem to think that fixing, and later finding the floating rate was cheaper, is evidence of a mistake....many won't even understand that comment.

To start with the future post peak oil will be nothing like the past.
Plus what you are suggesting I find hard to believe considering the GFC was in 2008.  I did my calcs in 2008 when I stayed floating, I have saved 4+K in that period.
Also are you picking a peak? I mean who takes a rate of 10% when its at its peak for 10 years (you can only do 5 anyway) when the average is around 7%?
regards

All fixed terms are short term in NZ, compared to USA UK where you can truly fix for the life of the loan. 
Banks may find borrowers less compliant this time around if these truly stupid hikes continue. 
Floating or 6 months gives you the option of moving to another bank remember.
Once fixed for 3 years or so, the bank has got you locked in with the threat of break fees. 
If you think that floating rates will hit 10% then you are obviously not doing your economic environmental scanning globally!

Doesnt even need to do that, our RB says 4.75% for the OCR which points at about 7.5% floating.
The rest of the world, well yes it looks to be in a really bad way. However if we see another 1929 (and I think we will) places like NZ will see the cheap money run back to the USA and we might find like Greece no one wants to lend to us...even at 30%!
We are in very starange times....unique...
regards
 

Well, so lets think about this........
First principles - banks actuaries and big brains look into future and offer a fixed rate that covers most eventualities in their favour.  Thats the rate you get offered. Any other approach would be nonsense form their point of view.
So if you fix, you are effectively paying a premium against some possibility of a rate hike of black swan proportions.
The fact that you cant fix further out than the medium term (more or less) means that even if the bank gets it wrong they can still get you next time.
In fact the further out you go the higher the premium you pay.
If you advocate fixing you are using fear of some event to drive people into making more for for the bank on the next spin of the wheel.
The point about retrospective analysis made by Grant A is a good one - the two options are equal retrospectively but not prospectively (I would suggest).
 
 
 

Im not sure the banks see a real possibility of a black swan. At least unlike myself if they do they have said nothing, nor have I seen any indication by action that they are covered for such things, ie another 1929 which I think is probable.
Lets look at the big brains outcomes since 2008, "rise coming".....RISE COMING"....ITS COMING!!!!!!  5~6 years later we have 25 basis points...yippee doodaa.  RB predicts 4.75% ish OCR in 2017(?) hardly a huge increase.
Personally I think they are interested in one thing, thier personal bonuses
Black swans, if there is any sense in trying to cover this then 6 or 12 montsh fixed low makes some sense.
regards
 
 
 
 
 
 

FYI I've updated with ANZ's latest property focus, which suggests fixing for 6-18 months makes the most sense.
cheers
Bernard

An article written by someone who doesn't understand interest rates, and doesn't understand risk management.

He makes some reasonable points:  
1. If you fix, you are immediately paying more than floating - so you lose immediately.
2. In the current global environment, floating is unlikely to hike to 12% plus
3. If you have a managable / medium sized mortgage you sholdn't be concerned with a hike or 2.
4. Once fixed, then you're locked into the bank  -  & are penalised for making extra payments and over-the-top penalised for early full repayment by the "so-called" "break fees"
5. Once fixed you can't change banks easily
6. The banks have already crunched the numbers, and you lose   -  as you do not have the access to their wholesale supply arrangements  -  information asymmetry
http://www.smh.com.au/money/borrowing/youll-never-beat-the-banks-by-fixing-your-rate-20140325-35er9.html
 
Fixing for 2 or 3 years is hardly a particularly risk-free option  - as in 2 years you're back into risk environment again.  You may need to do this 6 or 7 times over the life of the loan.

MB - the minute you see the opening statement "you'll never beat the banks by fixing your rate" anyone who understands banking and interest rates know the individual does not have a clue on either. Banks fixed rates are set by where the markets (not banks) set swap rates - swap rates are what banks use to hedge their risk. They can play a little with their margins over swap rates to try and gain market share, but it isn't margins being expanded that has pushed fixed rates higher in the past 6 months, its swap rates going up in anticipation of the OCR hikes
But let see on the others:
1. True but what he doesnt mention is that if the fix rate is correct you get the equivalant lower rate than floating in the second half of the term. - again, poor article
2. Probably true but we're not talking about 12% rates, we're talking trying to probably protect something well less than that - frankly for many leverage borrowers these days, 8-9% is the new 12%.
3. True, but how do you know it will only be a hike or two - you don't, and NOONE does.
4&5. Same point. Swiching banks is overrated as you only gain a temporary advantage. And yes, you do risk break costs (or nothing) if you need to break. However, thats only one side of it, the other is, if youre wrong about rates and 8-9% would kill you, youre dead and thats probably worse than a break cost
6. Read my opening statement on that comment - banks don't crunch numbers, the global market does and all theyre trying to do is work out where that floating rate will go over the period, and the fixed rate is effectively the average of that move. Its a automatic maths calculation as it has to be that.
 
I agree, you spread your risk across more maturities than a 2&3 yrs. The object is to manage risk by having things happen to you slowly over time so you can adjust to the change, not dumped on you in a year where that might be hard/impossible. 
 
 

As Steven pointed out above, those who floated or 6 month fixed since 2008 have saved a lot of interest over the last 4 years.   
Unless your mortgage is stretching you, why panic/worry about the peaks?
The point is that the banks have done alot of fear-mongering, & have persuaded many to fix against their best interest (excuse the pun!)
 

Peak? but really 7% is but a small hill, 10% Ok bit of a slog,18% now that is pain.   Of course these days 30 years and 95% isnt uncommon for a decent %...but whos the fool here?
regards