The seven considerations in deciding to float or fix

Friday, July 9th 2010, 12:35PM

Falling funding costs have led to a round of cuts in fixed rates. In the BNZ Weekly Overview economist Tony Alexander says new borrowers or those floating should consider fixing, but there are many caveats which mean for many, floating will remain the preferred option.

Alexander says last week BNZ noted retreating expectations about the speed with which monetary policies would be tightened around the world which on the face of it argues for staying at a floating rate as long as possible and taking a punt on the Reserve Bank pausing in their tightening cycle.

However, he says at the same time these changing offshore tightening expectations have reduced medium to long term funding costs and produced lower fixed housing rates here in New Zealand.

"So now we need to examine things again to see if we are still slightly in favour of floating or whether one might want to jump into one of the newly discounted one to three-year fixed rates purely in an opportunistic manner as discussed since the middle of last year."

Alexander says there is more to the fixing versus floating decision than just a simple comparison of fixed rates with forecast floating rates. Seven points he advises considering are:

1. This is not a repeat of the March 2009 situation when we advocated fixing. Back then people were moving from floating between 6.5% and 7.0% into fixing 6.49% or 6.79%. The majority made savings straight away. This time around jumping into fixed brings an immediate extra cost versus the 5.84% to 6.24% floating rates. In the current still very tight economic environment choosing to boost one's mortgage rate between 1.15% and 1.46% is a big ask.
2. Back then we strongly advocated fixing five or seven years in order to get great long term rate protection at a very low price. This time the five and seven year rates are not complete gimmees.
3. With a fixed rate one cannot get the benefit of offsetting positive balances in transactional accounts against the mortgage principal in order to reduce debt servicing costs.
4. The economy is improving (coughing a bit for sure but getting healthier), and that means many people will experience positive income surprises over the next couple of years. Such surprises can be used to reduce floating principal cost-free but break costs may apply for paying off fixed rate debt early (check the documentation).
5. If the global situation gets worse then we could see even further falls in fixed rates. One might want to hold out for such rates. We don't have a view that fixed rates will fall further but in an environment where credit demand from households is so very low one cannot rule out rate discounting.
6.  If globally things do get worse then maybe the Reserve Bank pauses more than two times over the next two years.
7. Apart from just pausing, what if there really is a structural change in household debt demand occurring in New Zealand? In that case the official cash rate is unlikely to have to be pushed by the Reserve bank to the 6% level we have used, so floating mortgage rates may not peak at just over 9%.

Alexander says the decision to fix this time around is not as clear cut as back on March 19 last year.

But then again, BNZ's call to fix was not based upon a view of what the floating rate was going to do but on when we figured fixed rates were at their cyclical lows.

"This time around my decision this week to fix is not based upon a view of where fixed rates go but where floating rates go over the next two to three-year periods taking into account the massive uncertainties which exist in economies and financial markets."

Alexander queries whether he would choose two years at 6.99% or three years at 7.30%, saying if BNZ's forecasts are right the Total Money floating rate will exceed 7% at the end of January next year and 7.30% by the end of March.

"I'd actually take the short term cash flow pain and fix three years, but I'd expect most people who do switch will opt for the two year rate as the jump from floating is less painful to immediate cash flows."

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