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Mortgage rates coming down, but there's risks in fixing too long


Mortgage rates are coming down, say ASB economists, making it risky to fix an interest rate for too long.

In its Home Loan Rate Report, the bank lays out the pros and cons of taking out mortgages for varying terms.

"Mortgage rates have been declining ever since it became clear that the RBNZ would move to cut the Official Cash Rate (OCR) as the economy weakened noticeably," said bank chief economist Nick Tuffley.

Fixed mortgage rates were the first to fall as wholesale rates progressively priced in the expectation of earlier and greater interest rate cuts from the Reserve Bank.

With the OCR itself now falling, floating mortgage rates have started to follow, he said. He expected the OCR to continue to decline to 5.5 per cent in the early parts of next year.

Mortgage rates will keep coming down as the OCR falls, but the financial markets have already factored in these continuing falls, so any drop in longer-term fixed rates was now "likely to be more muted".

"Short-term fixed rates and floating rates will tend to be the main movers."
But, on top of all this is "a large fly in the ointment", said Tuffley - namely the state of global credit markets which became "increasingly gummed up" over the past two months.

"For borrowers, a strategy at present would be to fix for only a short time to tide you over until mortgage rates fall further and offer a broader range of (lower) fixed-term options," said Tuffley.

"This strategy is not without risk given the current global uncertainties. If you place a high weight on certainty, a 1-year rate would give more peace of mind in the short term."

We expect the OCR will drop to 5.5 per cent by early 2009, with scope for more aggressive cuts if needed to counter the impact of global turmoil.

"Assuming some degree of order returns globally, we expect to see floating and short-term fixed mortgage rates to decline over the next 6 months. However, there is no guarantee that the long-term fixed rates will fall, and even if they do they are likely to remain at above average levels.

Our view is that the overall tug of war will be won by the RBNZ, but the impact will be felt mainly on the shorter term rates."

For prospective borrowers, fixing mortgages for short terms - possibly even going to a floating rate - would allow them to benefit from the falling rates.

But this strategy has its risks, says the ASB team. "If certainty is important, fixing for longer than 6 months may be a better compromise between cost and security."

The pros and cons:

Fixing for one year:

Advantages: It is below the average variable home loan rate forecast by the ASB for the next 12 months; there is also the potential to borrow at a lower rate in 12 months should the economic outlook pan out in line with the economist's expectations.

Disadvantages: Should interest rates actually rise further than expected then high rates will apply when coming off the fixed term next year.

Conversely should rates drop sharply you are locked into a higher rate for 12 months.

What the ASB economists say: "The 1-year fixed rate would suit those who prefer interest rate certainty during the period when rate rises are still a risk (i.e. inflation and global anxiety still high), or those who will be repaying their debt over the 12-month timeframe."

Fixing for two years:

Advantages: It is below the average variable home loan rate forecast by ASB for the next 24 months, with the added advantage of certainty for a longer period than shorter-term fixed rates.

There is a very reasonable chance that fixed rates drop by the time the term matures.

Disadvantages: Anyone fixing for this long misses the opportunity for lower rates should they fall over the next 6 to 12 months.

But there also still some risk of higher rates after the fixed term if, instead, inflation risks become much greater.

"The two-year rate is higher than our expectation of what you would pay by fixing for two consecutive one-year terms."

What the ASB economists say: "The 2-year fixed rate would again suit those who prefer interest rate certainty in the near-term but were willing to take the risk that interest rates will return to lower levels during the next 24 months."

Fixing for three years:

Advantages: The 3-year fixed rate currently offers the advantage of providing interest rate surety for longer;

Disadvantages: The likelihood of a missed opportunity should global and local inflation pressures ease and rates fall within the next 3 years.

"The current rate is high by historical standards, and also relative to where we expect shorter-term fixed rates to average over the next 3 years."

What the ASB economists say: "A 3-year fixed rate would again suit those who foresee interest rates returning to lower levels within the next few years but either prefer less risk or foresee the inflation and/or global debt adjustment process as lengthy (and interest rates slow to fall as a result)."

Fixing for five years:

Advantages: Surety for the next 5 years

Disadvantages: It is the highest of the fixed rates advertised at present - it is above the average 1-year Home Loan rate forecast by ASB for the next 60 months and, therefore, there is strong likelihood of missing out on the opportunity to benefit if fixed rates do decline within the next 1-3 years.

What the ASB economists say: "A 5-year fixed rate would suit those who strongly prefer interest rate certainty or who foresee a return to a period of persistent inflation. For the reasons discussed, we view it as the least likely choice to minimise long-term debt-servicing costs."



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