In the past 12 months advertised fixed mortgage rates have become more and more meaningless. With all of the focus on floating rates, lenders have bloated their fixed rate margins. In other words the term structure of mortgage rates is steeper than it needs be. When naval gazing your mortgage this sends a confused signal that ultimately could send you down the wrong path.
Unfortunately most bankers don’t understand the mechanics of mortgage rates. Head Office doesn’t show them the bank’s funding costs or margins. That’s why you’ll get generally confused advice from bank staff and why head office would prefer that their staff give no advice at all. It is also lost on most commentators when they debate the virtues of fixed versus floating.
Mortgage rate cards (the rates you see on bank web sites and on sites like www.mortgagerates.co.nz) are not reflective of the real underlying mortgage rates. As it stands today lenders are creaming it on longer-term fixed rates.
| Floating | 1 Year | 2 Year | 3 Year | 5 Year | |
| Advertised Mortgage Rate | 5.60% | 5.80% | 6.30% | 6.70% | 7.40% |
| Wholesale Rate | 2.87% | 3.05% | 3.28% | 3.50% | 3.91% |
| Bank Credit Funding Spread | 1.00% | 1.00% | 1.00% | 1.00% | 1.00% |
| Bank Funding Cost | 3.87% | 4.05% | 4.28% | 4.50% | 4.91% |
| Net Margin | 1.73% | 1.75% | 2.02% | 2.20% | 2.49% |
| Target Margin | 1.70% | 1.70% | 1.70% | 1.70% | 1.70% |
| Degree of “Over Pricing” | 0.03% | 0.05% | 0.32% | 0.50% | 0.79% |
| What Mortgage Rates should be | 5.57% | 5.75% | 5.98% | 6.20% | 6.61% |
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As the table shows, the 5-year mortgage rate is currently 7.40% but should be 6.70%. Without over complicating it, I’ve used the margin on the 1-year fixed rate as a baseline. You’d have to agree that at 6.70% a 5-year fixed rate looks quite attractive. On a similar basis the 2-year mortgage rate should be 5.99%, which again looks good, especially if rates increase by 0.50% towards the end of the year.
Lenders are comfortable with the focus staying on floating rates as it creates less price-based competition and bigger margins. With floating rate mortgages any competitively driven price change will impact on all floating rate mortgages, which makes changing prices prohibitively expensive.
With $96 billion of floating rate mortgages out there a 0.25% reduction in margin would cost lenders $240m in revenue. In a buoyant market the offset to margin reduction is volume. However, the market only grew by $100m of mortgage in July, worth about $1.5m in revenue. No lender is going to drop margins to chase this amount of anemic growth! Given the lack of growth in the market, it makes no sense to compete on price.
On the other hand, fixed rate changes only impact on the profitability of new business and fixed rate maturities. As such, lenders prefer to compete with fixed rates. That’s why lenders have occasionally promoted sharp 6-month and 1-year rates, but typically with no impact as homeowners have stuck with floating rates.
Don’t kid yourself, competition is still there, it’s just below the counter. Homeowners and investors can get sizable discounts on floating and fixed rates. You just need to be a sharp negotiator and understand the market, or have a broker that can do it for you. You should generally be able to get a floating rate below 5.50% even on your existing mortgage. We are currently getting floating rates as low as 5.25%, 2 year rates as low as 5.99%, and 3 year rates at 6.50%.
Ultimately the relative merits of fixed versus floating will come down to your own forecast/view on future rates. In the current climate this is a near impossible task, but that doesn’t stop any of us from taking a view, me included!
After all if rates did not increase from current levels, then 6.50% for 3 years would look expensive.
My view is that we have a weak global outlook that will keep rates generally low. However, in a NZ context 7.00% is still a low rate, and given the current floating rate is around 5.50%, we are likely to see some rate increases over the next few years. For me, the catalyst for rate increases will be property inflation in Auckland City. We cannot afford to see Auckland property prices take off again, and from what I can see, it’s already happening. The August QV report showed Auckland prices are now 1.5% over the 2007 peak. At some point I think the Reserve Bank will have to act on this in the absence of anyone else dealing with the underlying issues of land supply (dumb zoning) and government bureaucracy.
We also have the eventual stimulus that will get pumped into Christchurch. Most economists are forecasting reasonable strong growth for NZ in 2012, which if it arrives, will come with mortgage rate increases.
Either that, or the global economy will fall into a dark abyss, in which case keep everything floating.
