Fix or float? What to do with your mortgage rate??

For many New Zealand home owners, paying the mortgage is the single largest household expense each month.  Any increase in mortgage rates will naturally have a major impact on their budget.  With the latest Official Cash Rate (OCR) hike made last week by the Reserve Bank, an increase in mortgage rates is inevitable.  Many lenders have already increased their floating rates, and unfortunately, this looks to be the first of many hikes to come.  

So, what does this mean for home owners?  Based on this year alone, an increase of 1% will add an extra $742 per annum per $100,000 borrowed for holders of a 25-year principle and interest mortgage.  On a typical $300,000 mortgage, that equates to an extra $43 per week. For interest only borrowers, the situation is even worse – an increase of $1000 per annum for every $100,000 borrowed.

What drives an increase in mortgage rates?  As with many things, the answer is not simple and a host of inter-related forces come into play.  Supply and demand is an obvious driver.  If there are more people wanting to borrow money than there is money to lend, then banks respond to market forces and raise interest rates.  However, the most common driver is the action of the Reserve Bank and what it does with the OCR.  If inflation increases, then the Reserve Bank will usually raise the OCR to slow price increases.  A raised OCR usually translates to a raised interest rate.  And, at present, economic data is pointing to a stronger economy and concerns about rising inflation in the future.

The Reserve Bank has had some success in controlling house prices via macro-prudential regulation helping to cool the housing market.  However, it appears that New Zealand’s economy is growing at a faster rate than most other countries and with this momentum, the Reserve Bank is predicting increases to the OCR of around 2% over the next two years in order to stave off inflation pressures.  These increases will also help moderate demand for housing, in particular, in Auckland.

At the moment, it is approximately 1.5% more expensive to fix for five years compared to one year.  This means the market believes that at the end of a 1-year fixed rate term, if you choose the most logical loan structure at that point in time for the next four years, then the average you would pay over a 5-year term would equal the current 5-year fixed rate.  If that makes sense, you’re doing well!  Another way to say it is that the expectations of banks and economists of rising interest rates are reflected in the direction of the curve of the interest rate options (the yield curve).  For example, if rates are higher for the longer term fixed rates, the experts believe rates will be higher in the future.  So unless you have some secret inside information, you cannot outsmart the yield curve and benefit.

Currently, most outstanding mortgage lending is on floating or short-term fixed.  It is difficult to conclusively calculate if one would be better off fixing now for two or more years, continuing to float the mortgage, or go 50:50 fixed and floating.  This decision hinges partly on the outlook of the OCR and of course, also your personal situation.  Generally, a flat or falling OCR makes floating rates more attractive, whereas a fast rising OCR makes fixing more attractive.  Interest.co.nz has a useful fix or float calculator at http://www.interest.co.nz/calculators/55377/should-you-fix-or-stay-floating.  Although the calculator is numerically accurate, it is the assumptions behind it which can have a big impact on its accuracy.

At the end of the day, it comes down to affordability and what sort of risk one is prepared to take.  If you want absolute certainty on interest rates, then fix now and lock in a fixed rate (this being higher than the current floating rate, but likely to be lower than what the same duration fixed rate would be if you wished to do it this time next year).  One solution is to hedge your bets and fix 50% of your mortgage and float the rest. This potentially gives you the best of both worlds.  You have a known quantum to pay on the fixed portion for the next few years plus you can ‘gamble’ that the floating rate may take longer than the fixed term to attain the fixed term rate. Whichever option is chosen, you can be sure the cost of your mortgage is going to increase in 2014 and 2015.