The long and short of it
Mortgage rates are on the rise. Should investors lock in long-term fixed rates or stick to shorter terms in this environment asks Daniel Dunkley?
1 August 2021
In mid-July, the Reserve Bank New Zealand gave its clearest indication yet that it is prepared to raise interest rates this year. The central bank kept the official cash rate on hold at 0.25%, but reduced its monetary support by ending its LSAP quantitative easing programme from July 23.
The RBNZ also removed wording around needing “considerable time and patience” to meet its targets, fuelling speculation about an imminent rate increase. Strong inflation data in July has furthered the expectations.
Wholesale markets have reacted, and so have NZ’s major banks. The big four, Kiwibank, The Co-operative and TSB hiked most of their fixed rate loans in mid-July by roughly 30 basis points in many cases, with the rest of the market set to follow.
One year fixed rates now hover around the 2.5% mark, while five year terms are roughly 3.8% across the major banks.
Economists at ANZ and ASB believe the Reserve Bank could hike the OCR as early as August. Others pick November. The tide is turning in favour of rate increases, and many forecasters believe rates have troughed in this cycle.
With rates expected to rise further, what is the best mortgage strategy to pursue in this market? Leading economists have shared their view on the topic in recent weeks.
Investors Urged To Bolt In Long-Term Rates
With high inflation just around the corner, ANZ Bank, the country’s biggest mortgage lender, says mortgaged property investors would be wise to fix at least some of their borrowings at longer-term rates.
In a recent ANZ Insights Report, ANZ senior strategist David Croy says mortgage holders need to think “how exposed they are” and plan ahead for possibly higher borrowing costs.
Data for April shows about 76% of mortgage debt is either floating or up for rollover within the next 12 months.
Less than a quarter of mortgage debt is fixed for more than one year, and that’s low by historic standards. It means that when the Reserve Bank does start raising interest rates, it’ll bite sooner for most people. This traction will likely lessen how much they have to lift by, but it’ll come at a cost to many people, says Croy.
Given the growth in household debt, the economy’s sensitivity to interest rates is a lot higher. The household debt to income ratio has risen significantly over recent years.
In simple terms, more debt means more sensitivity to a change in interest rates.
ANZ is forecasting headline inflation to peak at 3% in the next quarter of this year.
Croy says this largely reflects factors that are not permanent, including Covid-induced shipping disruptions, which are feeding through into higher costs and prices, as well as a tighter labour market.
“Exactly how transitory or persistent (or even permanent) the lift in inflation proves to be remains to be seen, and there are plenty of mixed views out there,” says Croy.
“It matters crucially for borrowers given the Reserve Bank’s other objective is to get inflation sustainably to 2% and things are going well – almost too well – on this front,” he says.
“It’s looking like inflation is at more risk of overshooting than undershooting at this point. While we are yet to see actual CPI above 2%, the survey data suggests this is just around the corner.”
Croy says there are risks in both directions. Inflation may slump as the economy softens, and shipping disruptions ease. The housing market might cool more than expected, dampening demand.
“On the other side, inflation pressures could prove more persistent than expected if they feed into inflation expectations and wage growth.”
ANZ sees the risks skewed towards higher interest rates. It doesn’t, for example, expect to see interest rates fall again, unless another economic catastrophe comes along.
However, Croy says this cycle won’t be like the boom-bust cycles of old, where interest rates fell a long way, which stoked a recovery the Reserve Bank leaned against with higher rates, with the goal of engineering a soft landing at 2% inflation (and now full-employment).
“That didn’t always go smoothly – take the 2004-2008 cycle as an example, the Reserve Bank had to take the OCR from 5% to 8.25% before the economy slowed.
"When it did, the GFC saw it collapse, which by the way had nothing to do withthe Reserve Bank,” he says.
This time around, the starting point for the OCR is lower (0.25%). On the face of it, that suggests the OCR could go a lot higher before it gets back to more “normal” levels – it was at 1% pre-Covid.
Households also have less timecertainty with regard to how long they have locked in fixed mortgage rates for.
For borrowers, the “problem” is that on the one hand, you can still borrow very cheaply if you select a short term, but if interest rates rise, the cheap rate won’t be around for long.
Croy says the alternative is to borrow for longer – but of course that costs more – in some cases a lot more. There is no obvious win-win.
Mortgage Strategy Dilema
Borrowers could be better off fixing lowcost short-term mortgages and rolling them over a five year horizon, despite expectations of rising interest rates, according to ASB.
The bank has published its latest home loan rate report in which it suggests the official cash rate will begin to rise this year, peaking at 1.5% in 2023 and 2024. The lender’s economists believe that rates will settle around “historically low levels”, but slightly higher than its previous forecasts.
Reviewing different mortgage strategies, ASB’s forecasters said choosing shorter-term loans, and refixing each year could be the best option for many homeowners.
However, there is a growing risk that rates could rise faster and higher than expected, impacting borrowers following this strategy.
“Fixing for the lowest cost shorter terms and subsequently rolling fixed term mortgages is forecast to be the cheapest option over a five year time horizon. However, this strategy looks increasingly exposed to the risk of a faster than expected unwinding of monetary support, and a higher endpoint for the OCR (and mortgage rates) than our earlier forecasts.”
The economists called on borrowers to plan for rising rates, and said some may prefer the certainty of a longer-term fixed rate.
“Borrowers are prudent to do their budgets on higher interest rate costs rather than the rates on offer today. For those who want longer-term interest rate certainty now, the cost of fixing for two to five years is still very low compared to the past twenty years.”