How Long Should I Fix For? - What's the Deal?
Over the past four years interest rates in New Zealand have steadily reduced. The majority of us have been refixing on the 1-year interest rates and just rolling over year by year to a lower rate. Sadly that time has come to an end with the Reserve Bank of New Zealand (RBNZ) raising its’ official cash rate (OCR) by 50 basis points (bps) during the April meeting, and another 50 in May, compared with the expectations of a 25 bps increase. This was the fifth consecutive rate hike amid persistently high inflation. RBNZ mentioned that the annual Consumer Price Index (CPI) will peak at 7% and the “path of least regret” is to increase the OCR by more now, as opposed to later, to hear off rising inflation expectations. Globally, economic activity continues to generate inflation pressures amid ongoing supply issues driven by Covid-19. The Russian invasion of Ukraine has added to these challenges, causing prices of both commodities and energy to rise.
We now have five year fixed rate mortgage rates almost 3% higher than just over a year ago, and the one year rate over 2% higher. Renowned economist Tony Alexander has mentioned that he expects the OCR to peak at 3%, up from the current 2.0%. This would perhaps imply another 1% ongoing on the one year fixed mortgage rate (on average) and less than 0.5% for the long term rates.
Deciding how long to fix or float your home loan comes down to a number of factors. A good financial advisor will ask you a number of questions to truly understand your current financial position and what your desired goals look like. These could include questions like are you holding your property or selling it? How long will you hold it for or when are you thinking of selling? What rate are you on now and when does it mature? What are your short, medium and long term goals? What are your current debt levels, and what is your risk appetite in general? From here, our team can give great advice but the decision is ultimately up to the customer, and none of us have a crystal ball to predict the future exactly. It’s like the average house price in New Zealand, many are predicting a 10% reduction in house prices come early 2023, but if the last few years have taught us anything it's that everyone from economists to real estate agents to politicians and members of the public have shown they cannot accurately predict what house prices will do. At least with interest rates, we have a bit more control over this, however it’s not an exact science.
Floating Rates:
Lenders of floating-rate loans will lift or lower the interest rate as interest rates in the wider market change. This means your repayments may go up or down.
Advantages:
- You can usually lift your repayments or make lump sum repayments without penalty.
- You can use some floating rate based loans as a mortgage overdraft to enable you to save tens of thousands in interest and many years off your loan term.
Disadvantages:
- Floating rates have often been higher than fixed rates.
- When rates go up then repayments also go up, putting a squeeze on your budget.
Fixed Rates:
Advantages:
- You know exactly how much each repayment will be over the fixed term, which provides security and certainty.
- You can lock in your rates if you think market rates are rising.
Disadvantages:
- Fixed rates often have limits on how much extra you can make lump sum payments without incurring charges. If you decide to break mid fixed term you may be penalised.
- If you fix over a longer term, there is a risk floating rates may drop below your fixed rate.
It can sometimes be difficult to know which interest rate is best for your situation. Is it better to fix for one year, and fix again next year for another year, or should you just fix for two years today? The best way to figure this out is to think about what the interest rate would need to be next year in order to make fixing for two years today worthwhile. Generally the longer the fixed term, the higher the funding cost is for banks, so you pay extra for the additional security of this long fixed term.
If you wanted the cheapest possible rate today, you would probably fix your entire mortgage on the one year rate as this is usually the bank’s lowest headline rate. However, this isn’t necessarily always a great idea. If rates next year were to be significantly higher, you would have to fix your mortgage at a substantially higher rate which would mean a large increase in your payments, which can make budgeting and cash flow a challenge. On the flip side, if you wanted long-term certainty you could choose to put your entire loan on a 5 year fixed rate. This would be great as long as interest rates don’t fall, because if they do you’ll be stuck making much higher repayments than the lower market rate.
As I mentioned earlier, no one has a crystal ball and it’s not possible to see what’s in the future. Here’s where the concept of interest rate averaging comes in, which can be a great way to “hedge your bets.” This concept sees you split your loan into three portions and fix them for different terms (ex. 1 year, 2 year and 3 year, or 5 year). Over time, you’ll get an averaged interest rate and will have the chance to review a substantial portion of your mortgage every year or two, which allows you to assess your situation and also have access to the latest market rates, while still having the security of some of your lending locked in.
This is a very level headed approach and it means that you won’t win big by taking an immediate short term rate, but you also won’t lose big by getting hit with a massive increase to your repayments. If interstate rates continue to rise, only 1/3 of your loan is coming up for renewal at any given year, and at this time you can either re-fix or even move to floating if you have an inkling that rates could be dropping. It provides you the flexibility and choice to make a decision based on current interest rates and your financial situation.
