Bernard Hickey looks at whether to fix or float and how long to fix when the Reserve Bank is cutting interest rates & targeting Auckland property investors

Bernard Hickey looks at whether to fix or float and how long to fix when the Reserve Bank is cutting interest rates & targeting Auckland property investors

By Bernard Hickey

Even a few months ago, most borrowers thought the next move in interest rates was likely to be up and therefore fixing for as long as possible made sense.

So the June 11 decision by the Reserve Bank to cut the Official Cash Rate by 25 basis points to 3.25% and signal another cut has certainly taken a few by surprise. Floating mortgage rates were cut by the same amount and shorter term fixed mortgage rates have fallen as much as 50 basis points over the last six weeks.

Also, over May the Reserve Bank and the Government launched a pincer movement to try to slow house price inflation in the Auckland market, which Finance Minister Bill English has described as a "feeding frenzy."

The Government will introduce a "bright line" test from October 1 that will assume that anyone selling an investment property within two years of buying it is doing so as a trader and therefore must pay income tax on any capital gains made over that period. The Reserve Bank has also announced it will restrict Auckland rental property investors to no more than a 70% loan to value (LVR) ratio from October 1.

Many borrowers who are buying property in Auckland or elsewhere will wonder how this changes their decisions about whether to buy and how long to fix, if they're not already floating.

The mid-May announcements appear not to have had much impact yet on property markets, particularly in Auckland where sales volumes in April and May rose to record levels and median house prices also marched on up to new records. Auckland house price inflation is running at an annual rate of 15-20%, whereas inflation elsewhere is closer to 5%, or none at all.

Real estate agents and valuers however report a pick up in activity in Waikato/Bay of Plenty as investors spill out of Auckland with plenty of equity and look to keep borrowing above 70% in those markets outside of Auckland.

The question for many will be whether the slowing economy, thanks to a slump in dairy prices and weak wage growth, starts to drag on house prices. Certainly that slowing economic outlook is helping the outlook for interest rates.

March quarter GDP figures published on June 18 caused economists to slash their forecasts for the Official Cash Rate. ANZ now expects three rate cuts in 2015 and Westpac expects as many as four rate cuts, given inflation remains weak and consumer spending has been weaker than some forecast.

So how does this fit into the decision fix or float?

My view for several years has been that interest rates stay lower and for longer than most economists have forecast. They may even fall more than some expect.

That makes me more likely to fix for a shorter than a longer term. The banks subsidise fixed rates at the expense of higher floating rates, so even though floating should make more sense if rates were to fall, the cheapest most flexible option is a shorter fixed mortgage. The idea of a 10 year fixed mortgage scares me witless.

That rate of 5.95% for 10 years might have looked good earlier in the year, but what if the long term average for mortgage rates is in the process of a structural fall to more like 4-5% instead of the 7.4% we've seen over the last decade? Imagine the break fees on a 10 year mortgage.

Could they go lower?

The slump in fixed mortgage rates has made it much more difficult to justify paying the 6.5% offered by most banks for floating rate mortgages. The question then is: how long to fix?

The answer to that question depends on your view on where inflation in New Zealand and globally is going, and what you think central banks will do about it.

The jury is in overseas. They are treating this very low inflation and deflation as a cyclical issue that needs to be addressed with even lower interest rates and money printing. The People's Bank of China has also eased monetary policy repeatedly in recent months, as has the Reserve Bank of Australia. The Reserve Bank of New Zealand was an outlier for all of the last year.

Only the US Federal Reserve is talking about putting up rates, albeit from almost zero percent, but it has talked about it now for years without actually doing it. Some think there will finally be a US rate hike in September and longer term bond yields have risen through May and June, but there remains plenty of doubts about whether rates will actually rise much at all. There may be a small hike and then a long pause

The global trend over the 15 years has been for interest rates to fall ever lower. It's not just about falling petrol prices. There is now a growing debate about whether the deflation is structural and linked to changing technology, the globalisation of services and ageing populations. For now, central banks think it's cyclical. The wisdom of crowds in financial markets, particularly bond markets and stock markets, suggest it might be structural.

Structural or cyclical?

If it is structural then interest rates could remain low and possibly fall even further. Remember that interest rates averaged around 3% for all of the 1800s during the first age of industrialisation as new machines lowered the cost of production.

Some argue the world is entering a second age of industrialisation that delivers a similar type of 'supply shock' that lowers prices of goods and services for decades to come. The age of the smart phone has clearly driven down prices for many services, including shopping, accounting, music, telecommunications and taxis. Could we see many other areas such as education, health and financial services similarly transformed in a deflationary way?

Calculating the gains

There is a way to work out which mortgage and which rate saves you the most money, relative to floating rates. Interest.co.nz has built a special fixed vs floating calculator. See the table below for the latest calculations on a NZ$500,000 mortgage.

Here's a table that shows the benefits of moving a NZ$500,000 mortgage of moving from a floating rate of 6.5% 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 (5.0%) Two year fixed (5.2%)
OCR at 4.0% (low) + NZ$7,706 + NZ$9,417
OCR at 5.0% (middle) + NZ$10,628 + NZ$12,339
OCR at 5.8% (high) + NZ$13,843 + NZ$15,546

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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12 Comments

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Yes, agree, a series of 6 or 12 month fixes is cheaper than floating. However we are now going to see very tempting 2 year rates ( e.g. kiwi bank 4.99 2 yr).
However, on a floating rate you can jump immediately to a fixed rate if ominous signs point to a liquidity crisis or similar. If you are locked on a 1 year rate and things rapidly change you can't really react without paying break fees.
The floating rate is really priced too high from a retail/risk borrower perspective.

Have heard negotiated rate of 5.74% floating on offer. Prob best to lock for 6 months by which time 4.5% for 3 years should be on offer. We are looking at lower rates for longer - no chance of any increase in rates for the next 3 years. NZ economy is heading back into recession.

Nice article Bernard. I would like to add a couple of points.
1. Fixing is not just about trying to beat what the average floating rate would be over the term. It is also a risk management tool. No one can predict the future, no matter how smart they think they are. I also agree, floating rates are most likely to stay lower for longer, but what happens if they don't. Can a person with a high debt level afford rates back at the historical average? Just as someone insures there house from fire and pays the premium.. just because it hasnt been burnt down over the last 10 years does not mean they stop paying the premium for the protection.
2. There are two parts to interest rates offered.. being the underlying wholesale market which you mostly refer to and then the funding cost banks pay to raise funds to lend. Over the last couple of years this funding cost has been retreating massively, but there is growing concerns this may be reaching a low point. In theory, the RBNZ could cut rates and the rate a consumer sees could stay the same. Given how much debt we owe the world, it is a risk NZ is particularly at risk of and something like a Grexit would cause funding costs to rise rapidly.
Im sure you are well across all of this.. but the article probably overly simplifies the discussion a little. I agree that given the rates banks offer in the short end, it makes it hard to say no. However, to just dismiss a 10 year rate which was at the time extremely competitive seems a narrow minded. Would I do it? No.. but could it make sense for those seeking long term security: Absolutely.

good points - I just took a 5.4% interest only split for five years on a significant chunk of money- it gives me long term security in case of a major change - such as grexit - a further collapse in the kiwi leading to fast inflation - or another GFC. sure there may be a further downside - 5% maybe for that length of fix but it is unlikely to be a 3 or 4% rate - especially witht he rate curve steepening - But it protects me fro a sudden upside in a couple of years time to 8 or 9% happening fast whilst I am tied into 1 or two year fix .

the splitting of the loan allows me to focus all my repayment efforts on a smaller chink in this period - maximising the lowest rates available in short fixes - knowing that even if the wind changes suddenly in a couple of years time - this loan will have been significantly reduced nd the impact of a sudden climb minimised.

I am lucky to know I will never leave my property - so can eliminate some of those possible risks - but this is a strategy that totally insulates me for five years from significant risk - but still offers a chance to benefit form some of the very cheap rates - may not work for everyone but suits me.

And yes MB - it can get messy - I have three loans and an orbit but one of those will be fully repaid on the 20th :) - but I have a great relationship with my mobile lending manager over many years and have always got competitive rates so don't feel the need to play the move banks game either!

The odds of a house being totally destroyed by fire in NZ is less than 1%
About the same odds of interest rates reaching historical highs in NZ

Distribute the loan, based on current rates..(Good if you can get special discount for >20% deposit)

25/30% Floating
30% 6 months
20% 1 year
20% 2 years

Loan splitting can be a bit messy. And dissipates good gains from a really good rate e.g. 4.9%. Also messy to line up if decide to sell - you have to wait for the parts to finish various fixed segments. Otherwise, yes

I was thinking of a first home buyer, who is going to stay in the house for a few years..Investors have a different game and orientation and many go on interest only and prefer more floating, I guess.

Yes, however even for homeowners - average stay is 7 years. So if you get a job offer in another city or upsize for kids the break fees are worth considering. No one really can be sure of staying put.
The other issue is clarity: 5 loans are a mental load - & that is why debt consolidation loans are so popular. But splitting certainly good risk spreading tactic.

I fixed for 5.35% over 2 years (as the loan will be down to about $12,000) by then.

Now the rate has dropped a little and there are rates of $4.99 out there.
did I miss out? Over the two year period I would have saved an extra $200 not really worth worrying about.

It'll mean more to higher leveraged people of course, even several hundred k, a drop of even 40 bps really isn't going to wallop you.... if so, you're definitely outside your risk zone.

When things start get low and thin, a few points more off doesn't make a huge difference compared to what an upswing will cost. IMO, unseen and unheard of peoples' individual ciecumstances, and not being a financial anybody and thus not qualified to give advice. At below 5.5% you should be well within your yield range...anything you pickup from here down is a bonus but, like saving a few dollars in tax, it's just a bonus not something worth risk core business on.

An upswing though, then you're cutting through your yield quickly, reducing the equity growth/deleveraging portion. At higher rates, the need for top yield becomes difficult to obtain so things get much tougher.

Thus in this cowboys opinion if you're well below your yield & risk margin, any fix is ok.
But if your yield is light or your risk margin critical, it is far more important to fix to avoid damage.

I think you would have to be very careful in this economic cycle.
12 months ago experts told us interest rates would be going up instead they came down. We were told oil was going to go up to $200 per barrel, instead oil is now about $60 per barrel. The same experts told farmers to convert to dairy from sheep as there would be no limit on price and demand from China.
Prices are now 60% less than they were 12 months ago.
All these professional experts are now telling us house prices will keep going up due to the demand from immigrants and low interest rates. Unless you have a reliable crystal ball, then even the experts do not know what is happening.
If high house prices are caused only as a result of a shortage of houses in Auckland, then why are house prices rising by the same amount in most OECD cities? And why when 40000 people left to live in Australia several years ago did house prices not drop?
Economics is a very complicated science based on conjecture and graphs. NO ONE knows why and how things work when it comes to economics, if they did they would all be rich!
So be very careful when buying houses or fixing interest rates.
Do not rely on experts!

Liability markets have three very different components. One is price - the interest rate. Another is liquidity - the ability to borrow or lend. Then there's counterparty risk - the creditworthiness of the lender/borrower. Interest rates could be 0% or 20%, but without market liquidity and credit lines, no one will be borrowing or lending anything. Those who look solely at price to decide to fix or float should not ignore the other market aspects; the capacity of lenders, to lend and the borrower to borrow.

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