Exploding mortgage myths

By ANNE GIBSON

Rising interest rates are an incentive to pay off a house mortgage faster to reduce the cost of borrowing.

But Auckland investment adviser, portfolio manager and sharemarket analyst David McEwen says to think twice before upping repayments.

Although the interest bill will be lowered by fast-tracking repayments, inflation is eroding the value of our money.

In the McEwen Yield Report sold to subscribers, he examines the difference between repayments on a 10 and 20-year mortgage.

"Most people think paying off their mortgage fast is the best use of their money because the longer it takes, the higher the interest costs," McEwen says.

"That does not take into account the time value of money. Even in a low-inflation environment such as we have enjoyed for several years, our money is still losing value at the rate of 2 to 3 per cent a year.

"That means the money paid on a mortgage is going to buy less in the future than it will now."

The face value of the money repaid on a long mortgage is higher, but the value of those funds is different because of inflation, he says.

He cites a couple borrowing $100,000 for 10 years at 8 per cent a year. When they have made the last payment in 2012, they will have repaid $145,560. Another couple borrowing the same amount but repaying it over 20 years will pay $200,746.

"At first glance, the 10-year term seems more beneficial. Most people would rather have the difference of about $55,000 in their account rather than in the bank's. But the picture changes if we discount the repayments by a 3 per cent annual rate of inflation.

"In 10 years' time, the value of the first couple's last payment of $1213 will allow the bank to buy $900 worth of goods or services - a decline in the value of the money of 26 per cent. The other borrowers' last payment of $836 will give the bank only $460 worth - a drop in the value of the money of 45 per cent.

"During the life of their mortgages, the first couple are paying back $125,890 worth of capital and interest in today's dollars. The other couple are paying back $150,257. It is costing the second couple just over $24,000 at today's value for an extra 10 years of borrowing. Many would say that is a price worth paying to enjoy considerably lower monthly repayments."

As for interest rates, McEwen believes rates will rise again soon, which will affect mortgage holders. People wonder whether to protect themselves from rate rises by fixing the interest rate. This can reduce repayments, but can also mean missing out on any benefits if interest rates fall.

McEwen says a rise in mortgage rates from 8 per cent to 8.5 per cent will add $7500 to the cost of borrowing $100,000 over 20 years. A decline from 8.5 per cent to 8 per cent will save the same.

"Borrowers should be careful about locking into fixed-interest rate mortgages," McEwen says. "One disadvantage is that most banks charge a penalty to change borrowing terms. Banks go through phases of marketing fixed interest rate mortgages and the main message is that borrowers have the security of knowing what their payments are going to be. This is probably the only reason why someone should have such a mortgage.

"Banks promote fixed-rate mortgages when they expect rates to decline, potentially locking customers in at more profitable rates. Split loans, where a mortgage is divided into fixed and variable rate packages, are becoming more popular.

"This may appear to give the best of both worlds, but penalties on changing the fixed rate mortgage reduce their effectiveness.

"Fixed mortgages are not worth the effort, given the cost that banks charge for fixing a mortgage with any decent length. The average floating rate is 7.75 per cent and 8.20 per cent for fixing for five years. The Reserve Bank has indicated the official cash rate will peak next year at around 6.5 per cent, suggesting a maximum floating mortgage rate of 8.75 per cent.

"It may well decline after that - interest rates are notoriously hard to predict - so that someone who fixed for five years will end up paying more than they would if they had stayed with the floating rate.

"The average mortgage rate during the past five years has been 8.29 per cent. Unless inflation rears its ugly head - and there is no sign of that - then there is no benefit in fixing interest rates long term. Fixing at a lower rate for, say, one year at 7.5 per cent will save around $750 on a $100,000 mortgage. "That seems like a good deal. Fixing for two years at 7.9 per cent - assuming a further rise next year - would save around $120."

McEwen & Co.