Guest post: Residential home loans: fix or float?

Guest post: Residential home loans: fix or float?

Beam scales

In this article, John Bolton, CEO of Squirrel Mortgages looks at how to pick the right fixed home loan rate term in a rising interest rate environment.

This is particularly relevant right now, whilst everyone is talking up inflation and higher interest rates. One thing is for sure, you cannot avoid paying higher interest rates. The question is which strategy pays the lowest amount of interest over time.

Weighing up fixed versus floating over the long-term

In a past life when I ran the Product division of a bank, I had my team run a simulation across twenty or so years of interest rate data, to see what rate strategy performed better: float, fix short or fix long? The answer was overwhelmingly to continually fix for 1 year.

Short-term fixed rates perform better over the long run, provided you can handle a bit more volatility in your repayments.

This is similar to international research which suggests that long term, a floating rate home loan is better than a fixed rate. This would also be true in New Zealand if floating rate home loans were competitively priced. But they aren’t.

When an advertised floating rate changes, the lender’s whole portfolio of floating rate loans reprices. With fixed rate home loans, the only loans impacted by a price change are new settlements and roll overs.

The cost of competing with fixed rates is therefore lower than competing with a floating rate.

There is no polite way of describing what happens in New Zealand. Banks tend to ‘milk’ floating rates for extra margin and compete on fixed rates.

It’s not in a bank’s best interest to compete on floating rates because the cost completely outweighs any benefit. So, in the absence of competitive floating rates, the next best thing is the 1-year fixed rate.

The 3-year fixed home loan rate has increased over the past six months from 2.79% to 3.99% in anticipation of rate increases.

Let’s crunch the numbers

If you were to fix today for 3 years at 3.99%, to be cost neutral against fixing for 1 year for three years, the 1-year rate in a year’s time would need to be 4.30% and in two years it would need to be 4.50%.

The current 1-year home loan rate is 3.19%, and so already anticipates a 1.50% increase in the OCR (Official Cash Rate) over the next year. On the basis that all of the expected OCR rate changes come through, and that in a year’s time the forward outlook is still for further increases, then a 1-year rate of 4.30% in two years’ time looks about right.

However, what this doesn’t factor in is the impact on consumer spending of increasing rates.

With over $300 billion of residential home loans outstanding, a 1.50% increase in rates will take $4.5 billion out of disposable income. Then there is the loss of tax deductibility for investors which will take out another $1.5 billion over four years. Increasing rates ahead of the rest of the world will strengthen the New Zealand dollar and hit exporters at a time when they are finding it hard to export. It doesn’t look like tourism is coming back any time soon and a large number of small business owners have had their balance sheets ravaged.

There is a narrative about a queue of people wanting to immigrate to New Zealand, but I suspect that is changing as the rest of the world opens-up for business. If anything, we risk significant migration to Australia when we do eventually open up, given employment opportunities across the Tasman.

How strong is our economy?

When interest rates climb higher, the border opens, and post Covid fiscal stimulus stops, we will find out. I’m betting it’s not as strong as market pricing implies, and our Reserve Bank will need to hit the brakes sooner than the market expects.

All of this implies that if you can handle short-term volatility and higher home loan repayments, then fixing short-term is likely to be a lower cost strategy. If you prefer a bit more of a conservative approach, then splitting your loan across different fixed rate terms reduces risk and gives you some benefit from lower short term rates.

This article was originally written by John Bolton and published here.

How does this impact me?