Matt's Frequency Series (Opinion) - Mortgage Interest Rates: Are You a Cheapie or a Risk Manager?
Mortgage Interest Rates: Are You a Cheapie or a Risk Manager?
People often ask me about fixing the interest rates on their mortgage.
There are lots of articles around about how to manage your mortgage and pay it off quicker.
Clearly that makes sense. It is called a mortgage, but you are really only renting money. So, the less you rent for the least period, the lower the cost should be.
I’m only going talk about the fixing here. The idea is to provide a framework for positioning yourself around risk and understanding the choices available.
People fall into one of two groups here.
If you are a “cheapie” you will take the lowest mortgage rate on offer and ignore the term.
If you are a risk manager, running your insurance eye over your situation and the rates offered, you will look at your exposure to interest rates over time.
There is a real incentive to lock in your rates for at least some period. As I write this, one banks variable rate is advertised as 3.75. Fixing that for 6 months drops it to 3.55 and fixing it for one year drops it to 2.49. That’s a spread between the floating and one year rate of 1.26%.
So, it pays to fix, for at least some period.
The other rates currently offered in this example are:
Term Rate %pa
Variable 3.75
6 months 3.55
1 year 2.49
2 year 2.79
3 year 3.29
4 year 3.59
5 year 3.89
So, what would the cheapie group do?
Clearly if you want to pay the lowest price on offer at any reset date the one year will leap out at you. Job done for the cheapie group. That cheapie tag might sound a bit dismissive, but that approach has paid off very well over the last 3-4 years with rates dropping away.
So, what would an risk manager approach look like?
If you are thinking about managing risk, you would need to start by working out your situation.
You might want to think about:
How much debt do you have (dollars)?
How long will you be borrowing for? You might have year to go, or have you just signed up for a 30-year loan.
What does your free cashflow look like, are you struggling already, or can you absorb a percent or two without much pain?
Before we take an example from each end of the scale let’s look at what a neutral view on interest rates might look like.
In New Zealand you can generally only borrow fixed out to five years. So, a neutral view on interest rates might see you pitch into the middle of that range at 2-3 years. If you thought interest rates were going up sharply and for a while you might head to the five-year end of fixing. However, if you thought rates were low and going to stay low you might head to the one- and two-year range.
The new to housing young couple
So, let’s look at a first example. As a young couple in your first house, mortgaged to the hilt with a high ratio of loan to value (LVR) on a 30-year loan, and possibly plans for a family in a few years? You might look at those rates, figure you were going to be borrowing for a long time, and figure that your cashflow was reasonably tight, and might get tighter. Don’t despair, the bank already tested your ability to repay your loans at a higher rate, possibly up to 6%.
If that is your situation you might want to be more protected against interest rate raises. If a neutral view took you to an even split of the 2- and 3-year fixed rates, then you might lock in your rates for longer. That would carry an overall interest rate of 3.04%. That’s still very low from a historical perspective.
From an even split of 2- and 3-year rates the move to all at a three-year rate is costing you a quarter of a percent. In banking language that’s 25 basis points (100 basis points is a full percent). Moving from a three-year term to a to four year-term is going to cost you an additional 30 basis points. If you have the math’s and the inclination you can figure out what the implied rate for year two to three. In this case the answer from these rates is an implied forward 12-month interest rate starting at the end of year two of 3.79%
Like all insurance you have to work out how much cover you are prepared to pay for.
Armed with your knowledge of your situation, and the rates on offer you can work out just how risky your situation is, you can review to how much risk you want to take on, and much insurance you want to pay for at those prices for insurance.
Not a young couple in their first house with a high LVR?
At the other extreme, what if you are 50, have a well-paid job, and are going to comfortably repay your mortgage in the next five years?
In that situation the neutral 2- and 3-year rates are a starting point. The difference in rates for years 3, 4, and 5 may make no lifestyle difference to you. You may also either have no idea on which direction interest rates may go, or no wish to even think about it. In that case you can think about the benefits of paying it all off earlier, but you will perhaps get to the point that the choice of rates isn’t that important to you. Having a neutral view of 2- and 3-year rates hedges your bets and lets you sleep comfortably and focus on where to invest your money for a decent return once the mortgage is paid off.
Other things to think about
There are a bunch of other things to consider in fixing rates.
1. Shall I split my loans up so I can easily manage the loans separately, including when the rate fixes expire next time?
2. How much of the mortgage principle are you looking to repay in each of the next three to five years?
3. Are you looking to change banks? Having a long-term fixed rate can make that harder.
4. Are you looking to borrow again to buy another property?
5. Have you got something better to do with the money?
For an up to the moment view on where interest rates are and what one economist would do Tony Alexander has reintroduced a topic in his weekly commentary titled If I were a borrower, what would I do?
In those columns Tony makes the point that his advice is general and not personal. This column is the same. If you would like to discuss and understand your personal situation, please get in touch.