I have been asked a few times over the past week by property investors and home-owners alike why are the floating rate and 1 year or shorter fixed rates so much less than longer term fixed rates? Since interest is most investors and indeed home-owners biggest expense, as promised I wanted to provide a comprehensive answer to this. Currently the floating rates being charged (by the major banks) are in a range of 5.25% – 6.40% (5.99% is the average) , 6 month fixed rates average 5.8%, and 1 year fixed rates average 6.25%. Yet the longer term fixed rates are much higher with the average 3 year rate being 7.95%, the average 4 year rate is 8.50% and the average 5 year rate is 8.65%. Source: www.mortgagerates.co.nz
Now I know most of my readers are probably like the majority of our population and are better at assimilating information shown graphically, rather than nestled in a paragraph of text, so lets take a look at this graphically:
So why are the long term fixed borrowing rates so much higher than shorter term rates at present?
Currently the Official Cash Rate (“OCR”) is at emergency levels in response to the Global Financial Crisis (“GFC”). The OCR has a very strong correlation to floating rates, and also 6 month and even 1 year fixed term rates. We have floating rates currently sitting at 40 year lows. Banks aren’t going to lend you money at 5.75% for 5 years right now sorry, and nor are they likely to any time in the next 6 years in my opinion. Some of you will hopefully have joined me and taken my blog on 16 March 2009 seriously, and fixed for 5 years at 6.50% or 7 years at 6.79% with BNZ. I know many of my mentoring students are kicking themselves for not following my advice. Don’t worry as I am regretting that I didn’t fix more a bit more debt for 5+ years. Nowadays 5 years rate are coming down a tad, and the very cheapest 5 year rate is with HSBC Premier (the world’s largest bank) at just 7.95%.
5 reasons why there is such a difference now:
1. OCR doesn’t correlate well with long-term interest rates
The reason that the long term interest rates are so high is that the OCR has very little bearing on them. The US 3, 4 and 5 year swap rates have far greater bearing on our 3, 4 and 5 year fixed rates, than the OCR does. That said the OCR does have an impact. And this is expected to rise from its 2.50% low level towards around 5.00% over the next couple of years. Some economists are predicting the OCR to be risen to 2.75% on June 10th, however after the tax changes announced on May 20th this year in the Budget this year, I think that 6 weeks later in July is a more likely date for the OCR to have its first rise. The rising unemployment and lack of inflationary pressures are what makes me think differently to the majority of economists.
2. Risk premium for OCR rises
In addition many think that the OCR will be 1% higher at 3.50% come Christmas 2010. I don’t see this happening. Therefore there is a lot of upside interest rate risk priced these longer fixed rates.
The next 3 reasons arise from the three major funding channels: deposit rates, short-term wholesale funding, long-term wholesale funding.
3. Deposit rates:
Banks are under intense competition in the term deposit market. As a result the cost of deposits has greatly increased over the past year. Banks are attempting to ensure they maintain and grow, this source of funding. Banks also compete with a raft of recent corporate bond issues targeting retail investors. Six-month deposit rates were generally priced at around 40 basis points below six-month bank bill rates prior to 2008, but have recently risen to more than 100 basis points over six-month bank bill rates. Slightly ironically Kiwibank is again at the forefront of the battle for money invested in term deposits.
4. Short-term wholesale funding:
These costs have risen reflecting the increased spreads between offshore short-term funding rates and expected policy rates. As shown by the chart below, these spreads have risen substantially during the crisis – peaking in late 2008 following the collapse of Lehman Brothers that triggered the greatest impact of the GFC. These spreads have subsequently narrowed as central banks have provided increased liquidity and risk appetite has improved, but they remain above pre-crisis levels. The new Reserve Bank liquidity rules mean that more funding must be sourced from offshore on longer-terms, which means that long-term fixed rates borrowed in NZ will more than likely be matched by long-term wholesale funding. With most term deposit holders preferring shorter terms, there is increasingly less of a need for short-term wholesale funding.
5. Long-term wholesale funding:
These costs have eased from the highs seen in late 2008 – albeit to levels that are still significantly above those prevailing prior to the crisis. Long-term wholesale funding costs are proxied (given the limited amount of recent bond issuance by New Zealand banks) by movements in Australian bank bond spreads, with a margin added to reflect the higher cost for NZ bank issuers. Long-term wholesale funding has to increase under new Reserve Bank liquidity requirements – so longer-term fixed debt borrowed by a property investor in New Zealand, will more than likely need to be matched by borrowing this on the long-term wholesale funding market. This market is more expensive, as the risks involved in fixing a rate for longer are (rightly in many people’s eyes) greater. This new rule is a significant part of increasing the costs of long-term interest rates.
With acknowledgements to the Reserve Bank of New Zealand for answers 3-5.
Conclusion
So there you have my answers with some help from BNZ Chief Economist Tony Alexander in his latest weekly overview, ANZ National Bank Chief Economist Cameron Bagrie with his February Property Focus, and the good people of the Reserve Bank of New Zealand. As for what I am doing now on the debt I didn’t fix for 5+ years in March 2009, I am mixing it up a little bit between floating and taking 1 year rates. In doing so I am paying from 5.25% to 6.15% (I like and have good success in negotiating discounts to interest rates with banks but that is another special topic that I prefer to reserve for my paid mentoring students). With the ten year average interest rate across all categories (floating, 1 year, 2 year, 3 year, 4 year and 5 year fixed) averaging just under 8% now, I have big savings which I don’t blow on cars, lottery tickets or fancy holidays. I use this money saved to repay debt, by paying down principal on loans. Obviously if you have a mortgage on your own home, you should be paying down the principal on that firstly, as your own home’s debt is not tax deductible (I don’t want to know if you are one of the ‘special’ people renting their home from their own LAQC). Once your own home is paid off, then you can tackle the debt on your investment properties later!
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