Should you fix or float your mortgage?
The question to fix or float is nearly as old as mortgages themselves.
Mortgage competition is heating up in what has been called the ‘rate wars’ between banks and other financial institutions. Mortgage rates are determined by banks, typically based on the rate at which they can borrow from international banks and the Reserve Bank. The official cash rate (bank rate) has already dropped this year, and most NZ economists are picking at least another drop before Christmas. Even if this doesn’t occur, most commentators expect the tough competition for mortgages to continue.
That’s unsurprising really, as Kiwi’s now owe a whopping $266 billion on their homes – a figure that continues to grow (for the sake of comparison, in March 2019 the total invested into all KiwiSaver Schemes was a paltry 20 percent of that figure). Banks and non-bank lenders profit from lending people money to buy homes and charging interest on that money.
Of the $266 billion, about 80 percent is in fixed rate mortgages (when the interest rate is set for a fixed period) with the other 20 percent on floating rates (where the interest can go up or down at any time).
The main advantage of a fixed rate is repayment certainty. For a set period, you’ll know exactly what your payments will be. This makes budgeting easier and if rates rise, you won’t be affected.
The downside of fixed terms is that you can’t opt out of your fixed term – unless you pay a break fee, which may eliminate any savings you may have made. This also means if interest rates drop, you’ll miss out. In addition, usually banks charge a penalty if you make extra repayments above their extra repayment threshold during the fixed-rate period. Extra repayment limits vary from bank to bank.
The main benefit of a floating rate is flexibility. For example, if interest rates were to drop further, or if you came into some extra cash such as an inheritance, redundancy payment, or bonus from work and wanted to use it to repay some or all the mortgage with it.
However, you’re at the mercy of interest rate fluctuations – great if they go down, not so great when they go up! This can make it more difficult to budget, as your repayments may vary. Floating rates are also likely to be more expensive than fixed term mortgage rates.
Are there other options?
In addition to fixed and floating mortgages, there are also:
- Capped rate mortgages: A compromise between fixed and floating is a capped rate. If floating rates rise above the cap, the cap doesn't follow, but if floating rates drop below the cap, the capped rate drops too.
- Interest-only mortgage: you only pay the interest portion, so the principal doesn’t reduce. But you’ll have to start paying the mortgage sometime. Historically, this has been popular with property investors, though it can be a risky option if property prices drop and you must sell.
- Revolving credit facility: this works like a large overdraft. Interest applies whenever the account is overdrawn, and the account can be overdrawn at any time up to the maximum of the mortgage. Revolving credit is flexible, but you need to be disciplined at reducing the overdraft and avoid the temptation to never quite pay down the balance. A revolving credit facility is only available with a floating rate.
As some of you may have noticed, if you think an interest rate is favourable then you can lock it in for a set period. However, the banks and other lenders aren’t stupid, they do this every day, and so have teams of people dedicated to calculating rates based on the latest market data. Milestone Direct’s own internal research shows that over the last 15 years you would’ve been slightly better off having one- or two-year fixed rates than floating or fixing for longer-terms. However, that was over the last 15 years – there’s no guarantee the experience will be repeated moving forwards.
Just to confuse matters, there’s a lot of media hype and noise around interest rates and whether they’ll go up or down – even though the truth is that no-one knows for sure!
The decision about which is right for you depends on your income, personal circumstances, and ability to absorb changes to your payments. You should also consider your appetite for the uncertainty, or in other words, are you the type of person that will worry about the possibility of rates going up?
It pays to also consider splitting your loan and have a portion fixed and a portion floating, thus gaining the best of both worlds. This is particularly useful if you are expecting a lump sum soon but are not sure exactly when. Even if you’re not, having at least part of your loan on a floating rate means that if you receive an inheritance, win a lottery or get redundancy pay, you can pay down your mortgage without penalty.
While the choice between fixed or floating is important, there are other things to consider, including the rate(s) on offer. Negotiation of rates is usually possible, so don’t assume the advertised rate is what you must pay. You can also haggle on things such as interest rates and fees on other accounts, cash-back for new lending, and other ‘sweeteners’. This is where a professional can assist.
If you already have an existing mortgage, how about a free review of your lending? This complimentary review could save you thousands and help you become mortgage-free years faster. Review your mortgage.