Fundit.co.nz

Welcome to the first installment of a new weekly feature here on the Fundit blog, where I’ll be reviewing the bank’s regular economic reports, and, along with my own views, presenting the relevant points in an easy-to-read format.  I welcome your questions and comments – feel free to send them through to glenn@fundit.co.nz

Fix or Float?

With interest rates expected to rise over the short term many people are wondering if they should fix their mortgage for a longer term now, or keep it at a floating or short fixed term rate. In order to answer this question we essentially have to predict the future, so it’s worth seeing what information is around to base our decision on!

A good place to start is with current interest rates. Financial markets aren’t blind to what could happen in the future – indeed, current interest rates always reflect what the market thinks will happen to interest rates in the years ahead. With a few calculations we can therefore work out what the market currently thinks will happen to interest rates in the future. Below is a table (which I’ll be updating weekly), similar to that seen in ANZ’s monthly “Property Focus” report, telling us what the market thinks:

Some people will at this point be somewhat curious as to how the numbers in this table are generated – for a primer have a look at http://en.wikipedia.org/wiki/Yield_curve (scroll down to “Market expectations (pure expectations) hypothesis”).

As an example, imagine you’re thinking of borrowing money in two years time, and at that time you want to borrow for 18 months. Consulting our table, we see that right now the market thinks the interest rate will be 7.99% - this is the market’s current best guess of what the interest rate for an 18 month loan will be in two years time.

For another example (a little more complex, but stay with me), imagine that I want to borrow for two years. There are a number of ways I could go about doing this:

1. I could borrow for a 2 year term today at a fixed rate of 6.99%,
2. I could borrow for a 1 year term today at a fixed rate of 6.46%, then at the end of that 1 year borrow again for another year at whatever the fixed rate is,
3. I could borrow for 6 months today at a fixed rate of 6.09%, then borrow again after that loan ends for another 18 months at whatever the 18 month fixed rate is…

You get the idea.

Imagine I decide to proceed with option 2 above, borrowing for a one year term at 6.46% and then when that year is up borrowing for another year (for a total of two years borrowing). According to the table above, the market is guessing that one year from today the interest rate on a one year fixed mortgage will be 7.52%.

This result, although seemingly magical at first glance, derives from a simple principle: I really shouldn’t care which of the three funding options above I choose. It should cost me the same amount overall to borrow for 6 months and then 18 months, or to just borrow for 2 years up front, or to borrow for one year and then another year. If it were cheaper to borrow for 2 years up front, everybody would do just that – driving that interest rate up and eliminating any cost savings in the process.

This all seems a bit neat and tidy for the real world, and alas, it is. In reality, I would only be indifferent between funding options if the interest rate in the future actually was what the market guesses it will be today. But this almost never happens: if you could reliably predict interest rates you would be a very wealthy person indeed!

So what use is our table if it’s probably a poor reflection of reality? Well, even if you can’t predict interest rates with any precision, economists believe they can pick a range of probable interest rates with some accuracy. This implication is important, because (so the theory goes) we can use these predictions to get you a cheaper mortgage.

As an example (last one, I promise), imagine I have a mortgage and am trying to choose between

1. fixing for two years at 6.99%, or
2. fixing for 6 months at 6.09% and then for another 18 months at whatever the available rate is.

Suppose I choose the second option: what interest rate do I want to see in 6 months time to make this option cheaper than just fixing for two years up front? Consulting the above table, the maximum interest rate I want to see in 6 months (for an 18 month term) is 7.28%. If the interest rate in 6 months is above 7.28% it would have been cheaper for me to just borrow at 6.99% in the first place.

The real question then becomes apparent: do I think interest rates in six months for an 18 month fixed mortgage will be above or below 7.28%? If I think below, I should borrow for six months then 18 months. If I think above, I should fix for the longer two year term now. This is the question you should be asking yourself when choosing whether to fix or float: do you think rates will rise faster or slower than the amount in the above table? Who is right – you or the market?

What do the banks think?

Now that we’ve got a framework for making decisions let’s canvas the banks to see what they have to say. Turning first to the circumspect BNZ (http://bnz.co.nz/binaries/w150710.pdf):

“The RB would have to pause in their tightening cycle for a year to make one worse off fixing two or three years than floating at the moment. So I’d veer marginally toward fixing (probably three years) but most people won’t. That is because fixing at the moment involves locking in a rate well above current floating rates, and many people don’t believe the RB will keep raising rates in light of weak data.”

ANZ is more certain, although their last update was over a month ago (http://anz.co.nz/resources/1/f/1f62778042c59aa6a881a993a00affdf/PropertyFocus-20100806.pdf):

“Our broad preference for floating is based mainly on our view that interest rates will not rise as quickly as what is “implied” by the term structure of mortgage rates.”

ANZ, then, believes that the market is wrong and that the future interest rates in our table above are too high.

Finally, let’s look at Kiwibank (http://www.kiwibank.co.nz/personal-banking/home-loans/market-update.asp):

“we expect official interest rates to increase by about half a percentage point by the end of 2010.”

“Given the fragility of the global recovery (in particular in Europe), a concerted and immediate move to substantially higher rates is unlikely. The current and projected profile of mortgage interest rates suggests it would need a significantly large increase in floating rates in a year’s time for those longer-term fixed rates to yield an overall advantage.”

The author of Kiwibank’s market update, Dr Ganesh Nana, also offers the best advice of all:

“Above all else, it is wise to remain calm and not be panicked into making decisions.”