May 2010

There has been considerable discussion about whether interest rates will increase fast or slow. My take on this is that they will increase slowly - maybe bay 0.5% to 1% over the next 12 months. I feel that they will probably increase slower than 1%, but I have been wrong before. You may ask why that is what I consider as I am not always right & I am not that clever! Here is why I feel that rates won't increase very quickly over the next 6 months particularly, but over the next 12 months generally:

1. The economy is still very slow;
2. It is hard for businesses to borrow money for expansion; plant; etc;
3. Banks have considerable money to lend but they are resisting lending on anything but their assessed "safe" propositions;
4. Increasing the interest rates can increase the value of our dollar which is not beneficial to exporters;
5. The banks have all modified their interest rates recently to have the floating rate about 0.25% below their 6 months rate (roughly). This means to me that the banks expect to have only 1 interest rate adjustment in the next 6 months or so, they think that there is a chance for a second 0.25% increase, but that increase towards the end of the next 6 month period.
6. The banks are not sure of the number of potential interest rate increases or the size; therefore they are trying to keep borrowers on short term (floating) rates so they do not make losses.
I will compare the floating rate to the 6 month fixed rate for a hypothetical loan of say $100,000 over the next 6 months.

I have used the Sovereign rates - with the Money Science 0.1% discount - these are:
Floating is currently 5.75%.
Fixed 6 months is 5.90%
Fixed 12 months is 6.40%
Fixed 18 months is 7.00%
Fixed 24 months is 7.35%
Fixed 36 months is 7.75%
Fixed 48 months is 8.25%
Fixed 60 months is 8.55%
The information contained in this newsletter is intended to help the reader understand their options and to better make an informed decision. It is not possible to predict with certainty the likely changes in interest rates or any other market forces so the writer takes no responsibility for any losses made due to this information.

Today is the start - 14th May 2010. The loan is $100,000 and we decide to float for the next 6 months. Our interest rate today is 5.75%. This means our monthly interest cost is about $479.17pm. Let's assume that the interest rate changes on the next OCR announcement date of 10th June 2010. We will assume that the Official Cash Rate (OCR) is increased by the Reserve Bank by 0.25%. By the time our lender has decided to change their interest rate to us, and then posted us the letter, our 14th June payment has been made. Let's say they send us a letter in late June advising that out interest rate will increase from payment made 14th August 2010. Therefore we pay 3 months payments of $479.17 & then 3 months at $500.00 per month (based on 6%). That is a total of $2937.51 in 6 months which equates to an average interest rate of 5.875% (you will notice that this interest rate of 5.875% is exactly half way between 5.75% & 6%.

The comparison therefore is had we decided to fix for 6 months, at 5.9%, we would have paid $2,950 over the same period, therefore we would be worse off by about $12.49. YES, MARGINAL! Let's assume that we had fixed for 12 months on 14th May, and the Reserve bank increased the OCR every 90 days (about every second announcement) the following would be the likely affect on our mortgage:

Rates from the lender would likely increase by about 0.25% every quarter say 14th August, November, February & May.

Therefore our interest costs on floating would be $479.17 for 3 months; $500 for 3 months; $520.83 for 3 months & $541.67 for the last 3 months. Total cost on floating would be about $6,125.00 over 12 months. If we were to fix for 12 months at 6.4% then our cost would be $6,400.00 for the same period.

Even if rates went up every 2 months by 0.25%, our cost would be $479.17 for 2 months; $500 for 2 months; $520.83 for 2 months $541.67 ; $562.5 for 2 months & $583.33 for the last 2 months. Total cost on floating in this case would be about $6,375.00 over 12 months. Even if interest rates increase today & your mortgage increases from next month, then every 2nd month thereafter, resulting in a final interest rate of 7.25% in the last month; it would cost you exactly the same as fixing for 12 months today... $6,500 over the next year.

My summary is:
1. The banks have set their pricing so they trap clients into the shorter term loans or floating;
2. It is marginal fixing for the short term... The cost or benefit to you will likely be marginal;
3. It seems less likely that there is any benefit in fixing now for the longer term .

To decide whether to fix or remain floating here is how I do it.
This works for ANY fixed term
1. Choose a fixed term and rate; Let's Say 2 years at 7.35%
2. Halve the fixed term you choose; This is 1 year - This is what the interest rate needs to be in order for you to break even. 7.35% in 1 year.
3. Now calculate the difference in Floating to fixed rates (7.35% - 5.75% = 1.60%). Add this to the fixed rate we have chosen (7.35% + 1.60% = 8.95%)

This is what the interest rate needs to beat the end of the term in order for you to break even.
8.95% in 2 years

So in 1 year do you believe that the interest rate will be above 7.35%?
In 2 years do you believe that the interest rates will then be above 8.95%?

If yes, fix now.
If no, stay floating.

Remember, this is BREAK EVEN. For there to be any benefit in fixing the rates, the rates must actually be higher than 7.35% in 1 year & above 8.95% in 2 years for you to actually receive any benefit.

The banks don't like to lose so they "hedge" their position. They are at the moment by holding floating rates down to discourage us from fixing long term. My belief is that fixing based on the rates in this document is only beneficial for 6 months, otherwise floating is not much different. If the rates only rise 0.25% in the next 6 months, either fixing or floating will cost about the same.

If you need any help, please email me with your situation.