Is now the time to be fixing interest rates?
I must say one thing before we begin, I am no expert on economics and most definitely do not have a crystal ball to gaze into the future. That’s the problem, after reading articles nearly daily on the future of interest rates, one thing is certain, no one has any real guarantee of the long term trend of rates. It’s like a horse race; lots of experts before the race and only a few left after the race. It appears that you and I have just as much chance of picking the winner as anyone. That’s the bad news. The good news is that we can have a bet covering every alternative. We can predict that rates will go up and lock in now. We can hope rates fall and stay with variable. Or, the option I like, admit we’ve got no idea, sit on the fence and have a bet each way. Fixing half the loan and keeping the other half at a variable rate. That’s really your three options. Now let’s look at each one in detail and explore the pro’s and con’s of each. RATES UP - FIX NOW As you have no doubt heard on the media there are so called analysts who are predicting quite a sharp rise in interest rates over the next 12 - 18 months. Some are going so far as to predict a 3% rise in interest rates. This would take the lending rate to around 10%. Most analysts believe however that the rise will be more moderate and are factoring in somewhere between 1% and 2% rises. History shows us that the events rarely match the predictions. So don’t assume that rates will rise sharply. There are many factors out of our hands that will affect the rates in Australia, for instance, the increasing oil prices do put pressure on rates but this could also cause some slowing in the world’s economy and just as equally take pressure off them. It’s a fine line. If you believe interest rates will rise and you want to lock in your rate now. There are just a few sums you need to do to make sure that the decision is best for you; You need to establish whether there any exit costs to your existing loan, and if so, how much? Then you need to work out whether the costs are worth the reduction in exposure to higher rates, i.e. If rates jumped up to 8% next year, how much would I be saving having locked into 7.5% for five years. Is this worth paying the $2000 exit fees and paying the extra interest in the short term. Example John has an interest only variable loan of $300,000 currently paying 6.5% interest. His monthly repayments are $1625. His costs to get out of his current loan are $2000. He decides to lock into a fixed rate of 7.25%, giving him new repayments of $1875, making his repayments an extra $250pm.
If he stayed with his current variable rate loan and interest rates went up to 9% his monthly repayments would be around $2250pm. So John looking at a possible increase of $625pm if rates jumped to 9%, decides to lock in his rate at 7.25% for the next five years and accepts a lower increase of only $250pm. He considers this $250pm like an insurance policy, as he is guaranteed these repayments for the next
RATES DOWN - STAY VARIABLE If the world economy, and more importantly our economy stalls there is every chance that interest rates would stay where they are and possibly even go lower. Analysts agree that this is unlikely (at least the going down bit). However, they have been wrong before and undeniably will be wrong again. If you believe that interest rates are going nowhere you would be unwise to lock in the fixed rates, as to do this, you are usually paying a premium for this (higher rates than the standard variable) and at a minimum locked into a fixed period. With a fixed rate loan you will usually incur heavy penalties should you wish to get out of the mortgage. However, obviously if the rates go up so do yours, pretty much instantly. Interest rates can jump up very quickly and they hit the hip pocket very quickly with the large mortgages the average Australian has these days. If you are sensitive to rate rises this mightn’t be the best time to rely on fate. Home loan interest rates have been on hold for almost a year. But that quiet period may end soon: the Reserve Bank has signalled it will probably raise rates after the upcoming federal election. The Reserve, which sets the general level of variable interest rates to keep the economy growing steadily, reckons it needs to keep a lid on household borrowing and guard against rising inflation. A recent rebound in the Australian economy and a recovery in global economic growth now make a rate rise much more likely. The Reserve usually avoids raising rates in the lead-up to a federal election, making a post-election rate hike more likely. The good news is that analysts expect only a small rate rise - probably 25 basis points or about 0.25 per cent more on a typical home loan. A 0.25 per cent rate rise would add $16 in monthly repayments for every $10,000 of debt. Signs that the long property boom is slowing may further limit the amount of further rate rises. The Reserve Bank has kept the cash rate on hold since January as it weighs up its choices. It's being influenced by:
Whether last year’s two 0.25 per cent rate rises were sufficient to slow booming personal debt and take some of the heat out of the property market.
What is happening with interest rates in the USA and Europe. The rate of economic growth here and overseas. What impact higher rates would have on business investment and confidence.
What the Reserve Bank says In its latest quarterly statement on the economy, the Reserve Bank sent its strongest signal yet that higher rates were back on the agenda. "It would be surprising if Australian interest rates did not have to increase further at some stage in the current expansion," the statement said. The Reserve also expressed concern about rising inflation, saying the inflation rate "could be expected to rise further if the current strengths of domestically sourced inflation persist". In the past, the Reserve has used higher interest rates to control inflation and would not hesitate to act again if the risks increase. Stronger economy drives risk of higher rates The Reserve has kept rates on hold during 2004 because of lingering concerns about the state of the world economic recovery and slower economic growth here. Those fears have proved unfounded. As the Reserve noted in its quarterly report, the Australian economy has enjoyed a stellar run in 2004. "At present the Australian economy is continuing to experience a good pace of growth with relatively low inflation. The part of the economy that had been most prone to overheating in the recent period was the housing market and, as noted above, this is now in a process of adjustment," the report said. Analysts say the statement was shorthand for: "Rates are set to rise over 2004/05". Other signs of a healthy economy include:
The consumer price index rose by 0.5 per cent - less than expected - in the June quarter, taking the annual rate to 2.5 per cent. This is well within the Reserve Bank’s target range of 2 to 3 per cent. Jobs are growing strongly, with 21,600 new jobs created in July. The unemployment rate edged up over the month however it remains near record lows. Business confidence and investment are positive after a patchy start to the year.
On a note of caution, the Federal Government's tax cuts and $600-a-baby family payment are flowing through to the economy, boosting retail spending and driving up inflation fears. This may add to the case for higher rates later this year. Overseas interest rates heading up As the US and European economies return to strong growth, their central banks have begun raising rates to ensure sustainable economic growth. In early July the US Federal Reserve Bank - the equivalent of our Reserve Bank - started lifting rates. In the past, a rate rise in the US often sparked a follow-on rate movement in Australia. But that nexus has become increasingly frail as our economy becomes stronger and more globally focused.
Nevertheless, Australia cannot ignore international rates forever. The more rates rise in the US and elsewhere, the stronger the likelihood of an eventual rate rise down under. What the experts say Leading analysts generally agree that the latest economic data supports the case for a rate rise later this year. Here is what some experts told the Australian Financial Review newspaper recently: "I think it is a very close call on Australian interest rate moves. A lot will depend on the strength of the economy over the next few quarters and the extent to which inflation pressures emerge in the wage data." - UBS chief economist Scott Haslem "Rates are set to rise. Timing is the issue. We think the odds are that the rate hike will be delivered in December." - Commonwealth Bank chief economist Michael Blythe The case for and against a rate rise For:
The Reserve Bank still believes household borrowing (mortgages, credit cards, car loans) is increasing at an unsustainable rate. Inflation pressures, particularly higher petrol prices, rising wages and retail spending. Interest rates are rising around the world.
Against:
Underlying inflation is still low (2 per cent) The housing market and lending for investment properties is slowing Economic growth is forecast to slow in the second half of 2004 Some parts of Australia are still drought affected.
Play it safe with rates Guessing at future rate movements is always best left to the experts. Rates remain near historic lows, and nobody expects rates to rise as dramatically as they have at times in the past 20 years. However, borrowers must recognise that rates do rise. The cyclical nature of home loan interest rates should be taken into account when taking out a loan and planning your budget. Why rates rise and fall The Reserve Bank and its counterparts the world over use short-term variable interest rates to slow down or speed up the economy and control inflation. If these rates remain too low for too long, the rate of spending and borrowing can outstrip the economy's productive potential. The result is rising inflation and the risk of an overheated economy. Tips for beating the interest rate cycle
Budget for repayments at least two percent higher than you are actually paying. Opt for a basic loan with fewer features but a lower rate. Pay extra on your variable loan from the start. If your budget won't cope with many rate rises, now might be a good time to consider fixing. If you can't choose between a fixed and a variable rate, consider splitting your loan with half at the variable rate and half at a fixed rate.
How changes in rates affect monthly repayments($200,000 home loan over 25 years) Remember, most lenders will alter the length of your loan rather than your repayments.Source: eChoice Rate 5.5% 5.75% 6.0% 6.25% 6.5% 6.75% 7.0% 7.25% 7.5% 7.75% 8.0% 8.25% 8.5% Repayment $1228 $1258 $1289 $1319 $1350 $1382 $1414 $1446 $1478 $1511 $1544 $1577 $1610
Is it time to fix? The possibility of an interest rate hike seems highly unlikely before the Federal Election on October 9, writes Gillian Bullock. But if John Howard's warning that rates would rise sharply under a Labor Government were true, then should homebuyers be scurrying into fixed interest loans? Most market watchers have dismissed Howard's claims as scare-mongering. But even if rates were to show a modest rise, how likely are buyers to switch to fixed mortgages? If history is anything to go by, most Aussie home buyers will stick with a variable rate with all its associated flexibility. Late last year the number of home buyers with fixed loans of two years or more made up 14.4 percent of the total home loan market. This coincided with the two hikes in interest rates of 0.25 percent apiece in the last quarter. But with no rises in sight beyond that, the proportion of fixed loans had dropped to 7.2 percent by mid-year.
Some of this downward trend can be attributable to the evaporation of the fear of interest rate hikes although for many market watchers it is more a case of Australians' general preference for variable home loans. With a fixed interest loan, there are usually restrictions on how quickly you can repay the mortgage. For instance, you may only be able to pay an extra five percent off your loan than your negotiated repayments each year. And if you were to terminate your contract for whatever reason even if you were just moving house - then you might find yourself faced with hefty break costs. In addition, fixed mortgages are often at a slightly higher rate than variable loans. Indeed in recent times fixed rates have edged up as the world economic outlook improves. According to Infochoice, the best three-year rates range from 6.7 percent to 6.99 percent, although the number of those below seven percent is dwindling. Five-year rates are even higher. This compares with an overall market-average standard variable rate of 6.8 percent. Of course, with a fixed loan, you can know exactly how much you will be paying each month during its term. Consequently it can offer a sense of security in that you will be immune to any rate rise. For many, hedging your bets may be the best option. Have some of your home loan at a variable rate and the balance at a fixed rate. That way, if rates rise, only half your borrowings will be hit