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

By Bernard Hickey

The Reserve Bank is expected to hike the Official Cash Rate for a third time in three months on Thursday, which should force borrowers to revisit the age-old question of whether to fix or float.

Banks have also sharpened their fixed mortgage rates in recent weeks, making the fixed vs floating decision even more interesting. Banks have much lower profit margins on fixed mortgages and have been able to borrow cheaply on international markets.

That is making fixing rather than floating increasingly attractive for those calculating what is purely the cheapest deal. See the table below for the latest calculations on a NZ$500,000 mortgage.

The answer depends on the interest rates being offered, 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 6.5% (likely after June 12) to the various fixed options, assuming different interest rate tracks. The gains are indicated as a positive and the losses are negative. The middle track for the OCR is in line with market expectations.

The latest estimates, given the sharp drop in fixed rates in recent weeks, suggest fixing is cheaper than floating across the board.

What the bank economists say

Bank of New Zealand Chief Economist Tony Alexander argued in his June 5 weekly summary that he would look to fix most of a mortgage for three years. He pointed out how recent falls in long term wholesale borrowing costs in the United States had fed through into low long term funding costs. He also saw house price gains in 2014 that spread out from Auckland and Christchurch.

That has prompted banks to shift some of their point of competitive focus away from the short term fixed rates to medium to long term ones. The result is falls in those rates great enough that were I borrowing now I would hop out of floating and either fix for three years at 6.25% or four years at 6.59%.

After all, next week we expect the RBNZ to raise the cash rate another 0.25% and that will take floating rates to near 6.5%. Basically, unless you believe that the world is set for a new economic plunge or we are about to have a foot and mouth outbreak, fixing three years and beyond now appears optimal.

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.

Tuffley said in this May 13 housing confidence report he expected house price inflation to ease through 2014.

We are seeing very early signs of easing demand and supply increases. And it appears that the peak period of house price gains is behind us. Price gains are still expected this year, but the rate of house price appreciation is likely to be lower in 2014 than it was in 2013.

Westpac's economists said in this June 9 weekly commentary the current 2-3 year fixed rate specials offered good value and there was the prospect of a second wind for the housing market if the Reserve Bank didn't move to keep rates expectations high..

The standard fixed rates from around six months to three years appear to offer similar value, and are a fair reflection of where we think shorter-term rates are going to go over the next few years. However, there are a number of specials currently on offer, particularly for 2-3 year fixed terms, that are substantially below our expectation for short-term rates over those horizons.

Fixed rates are more likely to rise than fall over the next few months, so for those who are looking to fix there is little to gain from waiting. 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. 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.

We regard the recent drop in mortgage rates – the average 2-year rate has fallen 34 basis points in two months – as particularly significant. Along with the uplift in migration, it raises the possibility that the housing market could see a second wind, a prospect that the RBNZ would regard as very unwelcome.

So even if the balance of developments justifies a slightly less anxious tone about inflation than in the March MPS, and a slightly lower 90-day rate forecast, we expect the Reserve Bank will also want to prod errant financial markets into lifting two or three year swap rates

ANZ Economists said in their May 30 Property Focus their analysis indicated a two year rate was most attractive.

ANZ’s carded mortgage rates have seen a number of changes in the past month, with the bellwether 2 and 3 year fixed rates falling as competition in the mortgage market heats up, while shorter-dated fixed rates continue to lift in line with a higher OCR.

Borrowers with at least 20% equity will find it hard to go past the 2 year fixed rate special of 5.85%, which is back to December levels and now close to the cheapest rate on the curve. Breakeven analysis suggests there is lesser value in fixing for longer terms of 4-5 years, with these rates already higher in anticipation of the RBNZ tightening cycle.

They also said Auckland's housing supply shortages may not be as great as others fear, which raised the prospect that rents may have to rise or prices fall.

One of the peculiarities about Auckland’s housing issues has been the disconnect between the shortage thesis and lack of movement in dwelling rents. According to the March 2014 CPI, the annual increase in Auckland dwelling rents was 2.3%, not much above that of the 2% nationwide average and half the 4.9% rise in Canterbury.

Other motives, including the focus on capital gain, may be behind small movements in rents, but with rental yields in the Auckland residential market (around 4% according to our estimates) already very low in relation to (rising) interest costs, something has to give. Either rents move up more sharply or prices fall.