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

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

By Bernard Hickey

The Reserve Bank has hiked the Official Cash Rate four times this year and is now expected to hold until early to mid 2015, which should force borrowers to revisit the age-old question of whether to fix or float.

The bank is expected to 'pause' until March at the earliest and possibly as late as June 2015 before putting interest rates up again, although it is still expected to lift them by another 1% next year. See more detail here on the Reserve Bank's stance.

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 both international markets and local markets, where deposits are plentiful.

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 6.75% 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. See all mortgage rates here.

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

OCR rate by mid 2016 One year fixed (5.85%) Two year fixed (5.85%)
OCR at 4.0% (low) + NZ$3,633 + NZ$6,786
OCR at 5.0% (middle) + NZ$6,582 + NZ$9,736
OCR at 5.8% (high) + NZ$9,818 + NZ$12,972

What the bank economists say

Bank of New Zealand Chief Economist Tony Alexander argued in his August 7 weekly summary that he would look to fix most of a mortgage for three years.

Wholesale interest rates have not changed much, but competition between banks for home lending appears to have strengthened. By all means take into account the cash bonuses which lenders may offer if you sign up. But stay focussed mainly on the interest rates being offered.

I personally would remain willing to hop out of a floating rate and move most of my debt to a three year term. Maybe I would also fix some for two years given the strong competition currently in that term.

ASB's economists wrote in this August 1 Home Loan Rate Report that borrowers wanting some certainty could still lock in reasonable length fixed-terms at rates lower than the floating rate.

More interest rate increases should be expected over the next two years. Borrowers can at present lock in some certainty and pay a lower rate than current floating rates.

Floating rates should be fairly steady while the RBNZ remain on hold, but are still set to rise the most out of all the mortgage rates over the next year.

Westpac's economists said in this September 8 weekly commentary that the best deals on fixed rates were clustered around the two year mark, and fixed rates were cheaper than floating.

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. Among the standard fixed rates, the best deals for borrowers with a deposit of 20% or more are clustered around the two-year term, and these offer substantial value relative to where we expect shorter-term rates to go over the next two years.

There is little point in fixing for just one year, given that these rates are higher than the two-year rate in most cases. Opting for three- or four- year terms would require higher payments up front, but could help to insulate the borrower if the Reserve Bank follows through with an extensive OCR hiking cycle.

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

Although ANZ’s floating rate rose by another 0.25% last month in line with the OCR increase, our 2 year fixed rate special has been lowered by 0.10% to 5.99%. With no changes to any of our other rates, and the 2 year fixed rate so obviously out of line with other rates on offer, we see this as by far the most attractive option.
The 6 month rate is lower, and remains a good proxy for floating. But with the RBNZ still in tightening mode despite the prospect of a long pause, the 6 month rate is on borrowed time and we believe it is worth paying the small 0.04% premium to be fixed for 2 years. Longer-term rates look less attractive on a breakeven basis.

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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The New Zealand situation is odd.   Compared with the USA where mortgages commonly are 25 and 30 years at a fixed rate.  And no break fees.
Bargaining between 1 or 3 year fixed and some fine point of the rate, as we do here seems irrelevant.  Especially for those trapped in a large scale mortgage, struggling to pay interest, with no capacity to pay off extra capital.
 

Ignore the economists. I follow a very simple approach which is to fix on renewal at the cheapest possible rate (haggle on the cheapest rate). This doesn't always get the optimal result but historically has provided a far better result than when most people try to get tricky and beat the market or when they and protect themselves. For example my average rate for the last 4 years (ending in aug 2015) is 5.1%. Nothing special but co-workers fixed for 2 year periods and ended up paying at least another .5% than me.
If you can't calculate the optimal payment amounts you should be utilising a revolving mortgage equal to the amount you think you can pay off during the period while you are fixed.