Beware The Quick Fix

Sydney Morning Herald

Saturday February 23, 2008

John Kavanagh

Locking your home-loan interest rate at the wrong time can be costly.

Australian home buyers and property investors have been responding to rising interest rates by refinancing. They are looking for better deals and in a large number of cases are moving from variable to fixed rates.

Borrowers have, in the past, shown a strong preference for variable over fixed-rate home loans. When they have switched to fixed rates in the past they have tended to do so in response to concerns about rising rates.

The problem is that they have often shut the gate after the horse has bolted - made the switch to fixed at the point when the interest-rate cycle was reaching its peak. In their bid to avoid high rates they achieved the opposite result and got locked into expensive finance.

Borrowers who fix their rates now are running a high risk of making the same mistake. Most market economists are forecasting that after one more rate rise (at most two) rates will start coming down next year.

Australian Finance Group, one of the country's biggest mortgage brokers, reported earlier this month that record numbers of borrowers were refinancing. AFG said that 37 per cent of mortgages arranged by its brokers in January were for refinancing rather than property purchases.

AFG operations manager Mark Hewitt says the survey also shows that 24 per cent of all mortgages arranged were on fixed rates.

"The proportion of buyers choosing fixed rate mortgages remains near the high water mark," he says.

Another big mortgage broker, Mortgage Choice, reported late last year that demand for fixed-rate loans was strong. From August through to the end of the year 31 per cent of all loans arranged by Mortgage Choice brokers were on fixed rates.

In the view of some experts, these borrowers have left their move to fixed rates too late and anyone fixing now would be making a mistake.

The general manager of Infochoice, Denis Orrock, says the best time to move to fixed rates would have been three years ago. "For most of the past four years, fixed rates have been below variable rates - well below during the first half of last year," he says.

Over the past few months, fixed rates have been rising faster than variable rates and now there is no advantage to be gained. If you assume that rates will start falling next year, then fixing now could mean paying above variable rates next year.

Three-year fixed rates range from 8.29 per cent offered by Westpac to 8.8 per cent offered by Macquarie Bank. Commonwealth Bank's three-year rate is 8.55 per cent, ANZ's is 8.54 per cent, National Australia Bank's is 8.54 per cent, Bendigo Bank's is 8.39 per cent and BankWest's is 8.34 per cent.

Variable rates are higher. ANZ's standard variable rate is 9.02 per cent, St George's is also 9.02 per cent, Westpac's premium option home loan rate is 8.97 per cent, Commonwealth Bank's complete home loan rate is 8.97 per cent. NAB's standard variable rate is 8.98 per cent.

Bear in mind that most borrowers can negotiate a discount of 60 or 70 basis points off these standard variable rates. What this means is that in most cases a borrower is now better off with a variable-rate loan or at least no better off with a fixed rate.

The big question is what is likely to happen in future. Following the publication of the Reserve Bank's latest statement on monetary policy, on February 11, the consensus among market economists is that interest rates are sure to rise at least once more and maybe once more after that and then start to fall next year.

What has convinced the pundits that the Reserve Bank will increase rates again was its comment that: "On the current outlook, and allowing for the inevitable uncertainties in forecasting, the risk of inflation remaining uncomfortably high for some time is considerable. Absent a further shift in economic risks to the downside monetary policy is likely to need to be tighter in the period ahead."

Chief economist at AMP Capital Investors, Dr Shane Oliver, says rates will fall next year.

"It is always hard to know where the tipping point is but there are growing signs of mortgage stress that suggest consumers will soon start to tighten their belts and slow consumer spending," he says.

If a borrower is contemplating a three-year, fixed-rate loan, they need the average of the variable rate over the three-year period to be higher than the fixed rate if they are to come out ahead. In the current environment that is not likely to be the case. Some borrowers, such as investors and first-home buyers on low incomes, need certainty in their budgets. For them the extra cost of a fixed rate may be worth it for the security it provides. Think of it as an insurance premium.

Oliver says borrowers should take a longer-term view of interest rates when choosing between variable and fixed. "People need to get a sense of where interest rates sit over the long term.

"Economists use a concept called the sustainable cash rate. The cash rate set by the Reserve Bank has a relationship with the nominal rate of growth in gross domestic product and tends to fluctuate around that rate.

"The real long-term rate of economic growth is around 3 to 3.5 per cent. If you add inflation to that you get a nominal GDP growth rate of 5.5 to 6 per cent.

"If you then add the bank's interest margin on top of that you would expect the long-term average for variable home loan rates to be around 7 to 7.5 per cent.

"When rates get below that level it is time to think about fixing. When they get above that level it is probably too late. The problem is that most people think short term."

Our preference for variable rates is not shared in other countries. The standard home loan in the US market is a fixed rate that may be set for 20 or 30 years. Fixed rates are the norm in the New Zealand market. Our liking for variable has been put down to a gambling mentality - taking a punt that rates will go down.

Infochoice's Orrock agrees that borrowers think short term.

"Back in 2005 and 2006 there were great opportunities to lock in low rates for long terms. Not many people took advantage of that opportunity," he says.

© 2008 Sydney Morning Herald

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