As interest rates rise, it is prudent to plan for continued increases over the next couple of years at least. Here we discuss the current interest rate climate in New Zealand and share the recommendations of several bank economists to help you limit your exposure to help you limit your exposure to the spiralling cost of borrowing.
The setting of interest rates in New Zealand
Interest can be one of the largest expenses in any business or household. The banks vary their interest rates in response to changes in the official cash rate (OCR) set by the Reserve Bank.
Eight times a year, in January, March, April, June, July, September, October and December, the Reserve Bank reviews the OCR as a means of maintaining price stability and managing inflation.
If burrowing is cheap, the overall level of borrowing increases, stimulating the economy and increasing inflation. As confidence builds, the Reserve Bank raises interest rates to put the breaks on growth in the economy and to curb inflation.
The current climate
After sitting at a record low of 2.5% for almost three years, the OCR has been raised four times since March of this year and banks have responded by increasing borrowing rates. The Reserve Bank has indicated that interest rates will continue to rise, but more slowly over the next couple of years as the economy picks up. They have signalled that there will be a pause in OCR hikes until December at least.
New Zealand banks offer the option to borrow at fixed rates for a specified period or at rates that fluctuate (float) over the period of the loan, as interest rates change in response to market conditions and Reserve Bank policy. In some countries it is possible to fix your interest rate for 30 years, but here interest rates can typically be fixed for six months to five years, with BNZ offering a seven year option, currently above 7%.
At times like now, when interest rate are on the rise, short term fixed rates will typically be cheaper that floating or variable rates. The longer the fixed term, the higher the interest rate, with August advertised rates for six months being upward of 5.8% and for five years sitting at around 7%. Floating rates are around 6.6 - 6.75%. These rates are low in relation to the 10-year average.
Business / commercial borrowing is normally more expensive due to the higher risk that it carries. In most cases, however, even if you are borrowing for business purposes, you are able to benefit from the lower residential mortgage rate if the borrowing is secured by your home. Only do this if you know that you will be able to service the loan, otherwise you can risk losing you home.
Comparing the different mortgages options:
Floating (6.6-6.75%)
The current floating rate sits between the three and five year fixed rates for most banks. In a climate of rising interest rates, the key benefit of a floating rate is flexibility. You can lock in term rates at any time, and retain flexibility with principal repayments. If rates continue to rise more gradually than expected, this could also be a cost effective option over a five-year period.
Fixing for six months: (5.8-5.85%)
- This is the cheapest short-term rate. If you believe that the rate will be kept on hold for a while, your costs over this period will be minimal, and the option to fix in not far away.
- Even if rates increase as predicted and you do not plan to pay off lump sums in the short term, your interest rate costs will be lower than floating.
Fixing for one year: (Around 6%)
- This is the next lowest rate, being a bit higher than the six-month rate.
- You can budget cost reliably for one year, after which you will be able to reconsider your options. This is, however, a more risky strategy when there remains quite a lot of uncertainty in forecasts. If interest rates rise faster than predicted, your costs will be higher in the long term.
It may suit you if you need certainty and low costs in the short term, with the ability to review your options in a year.
Fixing for two to five years: (Around 6-7%)
- The longer the period for which you lock in your rate, the greater your certainty and better the hedge against interest rates rising faster than predicted. However, the longer the fixed term, the less flexibility you will have.
There is a strong argument that if you know you can comfortably afford the rate, then the longer you fix it at times when interest rates are rising and predictions are uncertain, the longer term you should choose.
This argument would suit someone who is risk averse and who values certainty over flexibility for the period of the fixed term. If this applies to you, here is a quick tip: Fix for the longest period that you know you can comfortably afford and forget about it. Do not keep comparing the rates over time to determine whether or not you have had the cheapest option. If you end up paying more, but can afford it, then consider the additional cost as insurance for peace of mind.
It is fair to point out that based on current predictions, fixing for five years is likely to be more costly than other shorter term alternatives. See recommendations of bank economists below, based on interest forecasts.
Breaking a fixed term contract and restructuring your mortgage.
Having spoken a bit about flexibility, let us look at the consequence of breaking a fixed term contract and restructuring your mortgage. You may wish to do this to reduce your debt or to lock in an attractive rate for a longer period to limit your risk.
Breaking your fixed term when interest rates are falling can be quite expensive as the bank will need to be compensated for the loss associated with having to relend the money at a lower rate.
However, with interest rates rising, the cost of breaking the mortgage and restructuring the debt should be limited to an administration charge imposed by the bank. This is because the bank will benefit from relending the money at a higher interest rate.
Make sure that you understand the terms that apply to your mortgage and discuss the financial consequence with the bank before taking steps to break a fixed term contract.
What the experts have been saying within the past month:
ASB Chief Economist, Nick Tuffley stated in the latest ASB Home Loan Rate Report:
"Borrowers wanting some certainty can still lock in reasonable length fixed-term at rates lower than the floating rate... and even lower than where the floated rate is expected to be over the period of the 1- an 2-year fixed terms.
"...Splitting the mortgage into different terms, or a mix of fixed and floating mortgages can be a good strategy for keeping a bit of flexibility while locking in some interest rate certainty."
In the ANZ Property Focus Report, Chief Economist, Cameron Bagrie commented on the ANZ interest rate changes subsequent to the July OCR hike, adding:
"...we still regard the 2 year rate to be the sweet spot."
Tony Alexander, Chief Economist at the Bank of New Zealand recommended fixing most of a mortgage for three years:
"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."
In the Westpac weekly commentary dated 1 September, Chief Economist, Dominick Stephens, points out that floating rates usually work out to be more expensive for borrowers than short term rates. He adds:
"Floating may still may be 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... 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."
Summary
Confused? No Need to be. Here is the advice in a nutshell:
- If you are looking for the cheapest option based on current predicitons, fix for two years at 5.99% or better.
- The three-year option is also attractive at 5.99% or better.
- The three- year option is also attractive at 6.19% if you would like certainly for a longer period.
- If you are risk averse and can comfortably afford a higher rate and can comfortably afford a higher rate so that you know exactly where you stand for the next several years, fix for the longest period that will suit your risk profile and pocket.
- If you require repayment flexibility, stick with floating.
- If you want to lock in some interest rate certainty, while retaining some flexibility, split your debt into different terms, or a mix of fixed and floating mortgages.
Finally, Nick Tuffley of ASB sums it up as follows:
"Ultimately the best mortgage strategy is one that also takes into account an individual borrower's cash flows, tolerance for uncertainty, and ability to deal with changes in future mortgage payments as interest rates change. It is always important for borrowers to weigh up their own priorities and make the mortgage choice that looks the best aligned with them: There is more to it than just picking the lowest interest rate."
Source: Business Advisor: September/October 2014 Issue