How to structure your mortgage in the current environment

February 12 2018  |  4 min read

In theory it is possible over the life of one’s mortgage to achieve the least possible interest cost by correctly predicting how interest rates will change. The chances of doing that however over a 25 year mortgage span are virtually zero. Same for 15 years. Same for ten years.

Before the global financial crisis of 2008-09 we economists used to think it was reasonable for people to believe we could predict borrowing costs out for five years and suggest whether to fix or float. But not now.

Virtually every interest rate prediction made here and overseas since 2008 has been wrong. In particular, multitudinous predictions and warnings of sharp hikes in interest rates made since 2010 have been incorrect every single time.

What has changed is that even in countries like NZ and the United States experiencing good jobs growth, wages growth has barely lifted. That means businesses have been under little pressure to raise their selling prices. But more than that, even when business operating costs have risen we consumers have become much more resistant to price rises. We quickly search online for alternatives. This equates to a big margin squeeze for many companies – but that is a separate issue.

Four things to think about 

The key thing here is that inflation has simply not lifted as expected so central banks like our Reserve Bank have not had to boost interest rates. Actually our central bank did in 2010 and again in 2014 but on both occasions they had to quickly slash rates lower because inflation failed to appear as they had forecast.

Just a few days ago we saw the Reserve Bank once again push out further in time the period when they think inflation will rise back over 2%. And just a few weeks back we learnt that inflation was much lower than expected late last year and it has fallen to 1.6% from 1.9%.

Thus we have four things to think about when considering whether to fix or float our mortgage rates. Will inflation jump up? Probably not for quite some time. We will believe it when we see it. Will interest rates rise? Our central bank may not push its main interest rate up until 2019 or in their estimation 2020. But before then we expect fixed lending rates to creep higher courtesy of higher interest rates in the United States.

These two things are both very uncertain. But the third and biggest uncertainty is this. If we cannot adequately explain why our wages, inflation, and interest rate forecasts have been wrong since 2008, how can we ever reasonably know when old relationships might reassert themselves? In other words, can we ever rule out an interest rates shock? No.

And fourth, can we rule out a downward rates shock perhaps because of Korean conflict or Chinese debt shock?

Spreading the risk

The answer is again no and that is the key to deciding how to structure one’s mortgage in New Zealand at the moment. You spread your risk to reflect the uncertainty. No forecast can justify we economists recommending fixing everything three or five years. No forecast equally can justify simply sitting floating or completely fixed one or two years. 

Instead taking a mix of terms looks best, biased perhaps more toward one – two years as opposed to two – three years because of the relative costs. Having a tad floating to give some repayment flexibility is also a good idea.

A key point to remember however is this. We do think interest rates will eventually rise even if not by all that much. When that happens people will look back and say they should have locked everything in for three years – or five years in the event of an upward rates shock. That is why it is a very good idea to “bank” the cost savings on a discounted short term fixed rate by accelerating principal repayments rather than perhaps buying extra coffees throughout the year. 

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