Mortgage borrowing strategy

Tuesday 24 February, 2009

Mortgage rates have fallen steeply. In the current economic environment, and given our interest rate projections, we favour fixing for a shorter duration. The 6 month maturity still looks to be the sweet spot at this juncture.

Our view

Retail mortgage rates have fallen hand-in-hand with the OCR and wholesale interest rates, and are likely to continue to do so. Wholesale credit markets remain “difficult”, but they are improving and if that continues, will enable lenders to pass on cost savings. However, the economy faces significant downside risks, and if they materialise, interest rates are likely to remain lower for longer. Even though interest rates are very low, with an economic recovery some way away, the scope for interest rates to head higher is limited, and as such, we don’t believe borrowers should be in a hurry to extend fixed terms.

Themes we favour in the current environment

There is no doubting that mortgage rates are attractive at current levels, which gives rise to the obvious question – is now the time to switch to a longer term fixed rate? As always, this is a tricky question to answer.

However, things that may influence the outcome include:

1. The structure of mortgage rates: the fact that short-term fixed rates are lower than long-term fixed rates. Making the decision to extend your fixed rate term is therefore likely to cost you more. However, as the general level of interest rates fall, this situation is likely to endure, so when the time does come to lock in for an extended period, this is an expense you will be faced with anyway.

2. The floating rate: The floating rate remains the highest rate. Choosing the floating rate is therefore an expensive decision to make. However, it may pay if interest rates fall quickly.

3. Motivations: extending your term is likely to be motivated by a desire for certainty, and the trick is to make that decision when you think rates have got to a level you’re comfortable with, and/or you think they aren’t likely to go much lower. When long-term rates were lower then short term rates, the decision to fix for longer was more difficult, as you also had to think of the cashflow savings that went with a cheaper rate. However, this is no longer a concern.

4. Breakevens: Thinking about where rates need to be in the future will allow you to make better decisions. For example, when choosing between, say, a 5.79 percent 1 year rate or a 5.95 percent 2 year rate, one thing is for sure – if the 1 year rate ends up at or below 6.11 percent in 1 year, you’d be better off choosing the 1 year, and then re-fixing again in 1 year. The breakeven rate of 6.11 percent is quite a bit higher than the current 1 year rate – is that likely?

Taking these factors into consideration, we favour the 6 month, which is currently at 5.99 percent. This isn’t the lowest rate available, but it’s very close to it, and our sense is that by the time it rolls off, longer term fixed rates (such as the 5 year, currently at 6.50 percent) will be lower. Of course, if something unexpected occurs in the next 6 months and it looks like mortgage rates start heading higher, if you do decide to break and re-fix, with such a short term remaining, break costs are likely to be relatively low so it’s a cost-effective option from both sides.

Source: National Bank, Property Focus