How long to fix a mortgage? The pros and cons

ASB Bank chief economist Nick Tuffley

ASB bank economists have today published their latest home loan rates report, written before Bollard's announcement this morning.

Future cuts in the Official Cash Rate are expected they say, "but they will be more modest in size." Short-term mortgage rates should remain low through this year..

The trade off to make, they say, is between low floating and short-term rates versus paying up for certainty of long-term rates.

"Financial market developments and the sheer volume of shifts into fixed-rate mortgages have driven long-term wholesale rates dramatically higher in a short space of time, closing the window on attractively-priced long-term rates very abruptly."

Long-term fixed rates still offer a high degree of security, though at a cost relative to very low short-term rates.

"Instead of the clearer option to fix for long terms at low rates borrowers now have to think through several possible options: remain floating in case long-term rates subside to a degree; fix for a medium term (e.g. 2-3 years) at a relatively low rate; take the certainty of a long-term rate even if the rate is no longer as advantageous as it was recently. "

If the RBNZ keeps the OCR low through to mid-2010 (as seems to be indicated by Bollard's comments this morning) then the ASB economics team expects floating rates to "remain at a very low level for the next year or more."

In the short term, there is, says the ASB economists, the possibility that long term rates will fall from their March peaks.

"Our core expectation is short-term interest rates are likely to fall further in coming months. Long-term rates might reverse some of their recent surge, but there are no guarantees."

The report lays out some of the pros and cons of choosing different terms for a mortgage:

Advantages of picking a 1-year rate:

- An immediate saving compared to a floating mortgage, as a 1-year mortgage is typically lower than the floating rate.

- Aside from the 6-month rate it is the lowest rate on offer at present.

Disadvantages of picking a 1-year rate:

- Slightly longer terms will provide the benefit of low rates for much longer, on the assumption the Reserve Bank will look to raise the OCR at some point in 2010.

- Conversely, should rates drop further than the RBNZ's latest outlook suggests, you are locked into a higher rate than otherwise for 12 months.

- There is the potential to borrow at an even lower rate over the coming months if the RBNZ aggressively cuts, particularly if the economic outlook pans out worse than current expectations, and the RBNZ takes the OCR below the current expectation of 2.5 per cent.

The 1-year fixed rate would suit those who prefer some interest rate certainty, or those who will be repaying their debt over the 12-month timeframe.

Advantages of picking a 2-year fixed rate:

- It is around the average Variable Home Loan rate forecast by ASB for the next 24 months, with the added advantage of surety for a longer period than the shorter-term fixed rates.

Disadvantages of picking a 2-year fixed rate:

- Missed opportunity for lower rates should rates decline over the coming months.

- The risk of higher rates after the fixed term, assuming global economic conditions stabilise in line with expectations.

ASB economists say the 2-year fixed rate would suit those who prefer a degree of interest rate certainty in the near-term at a relatively low rate, or those who will be repaying their debt over the 24-month timeframe.

Advantages of picking a 3-year fixed rate:

- Providing interest rate surety for longer.

- An opportunity to lock in rates which are below average or typical during normal economic conditions.

- The rates available now are well below what we would expect over the next 5 to 10 years.

Disadvantages of picking a 3-year fixed rate:

- Missed opportunity for lower rates should rates decline over the coming months.

- The risk of higher rates after the fixed term, assuming global economic conditions stabilise in line with expectations.

Advantages of a 5- year fixed rate:

- It is around the average Variable Home Loan rate forecast by ASB for the next 60 months, with the added advantage of surety for a much longer period than the shorter-term fixed rates.

- It is also below the average term rate available over the last 10 years, so in this sense, remains relatively reasonable.

Disadvantages of a 5-year fixed rate:

- Missed opportunity for lower rates should rates decline over the coming months.

- It is now significantly higher than the shorter-term rates on offer, and higher than the variable rate.

- At around 7.5 per cent it may no longer be the cheapest option over the next 5 years to shorter terms, in contrast to the case when the 5-year rate was still in the 6 per cent plus range.

"What the 5-year term provides is certainty, particularly if interest rates rise quicker, or to higher levels, than our current forecasts suggest. This certainty now comes at a higher cost than it did."

Longer-term rates would suit those who foresee interest rates returning to normal levels within the next few years, and want to lock in below-average rates now. They also, say the ASB economists, suit those who do not see a need to restructure their finances over the loan term.

"Just remember the only certainty about the future is it is uncertain. Which mortgage rate turns out to be the 'best' will only really be known with hindsight."

interest.co.nz's mortgage rates table