In a fix: Should you gamble on one-year mortgage rates?

COMMENT: Mortgage retail rates are now at record highs, and Kiwi homeowners face tricky decisions around how to structure their mortgages.

The big question on every mortgage holder’s mind is: Should I fix for a shorter term and hopefully emerge into a lower interest-rate environment, or fix for a longer term for stability of payments and to hedge against the risk of rates going even higher.

In the current cost-of-living squeeze, every dollar counts. The right decision could mean thousands of dollars in savings.

And market conditions are confusing. In May, the Reserve Bank indicated the rate hiking cycle was paused. This week it indicated there could actually be a further hike. Retail rates have continued to rise, and it’s possible they’ll go even higher.

So how should you structure your mortgage for the best financial outcome? It is a difficult question. But we have come up with a way of making the decision just a little easier. Spoiler alert - it requires considering what future “break-even” rate would mean you are better off fixing for a shorter term, or one longer one. It’s a calculation you can do at home.

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But first, let’s step back and consider the current state of play. In just two years, the Reserve Bank has increased the Official Cash Rate a dozen times, hiking it from 0.25% to 5.5% now. Homeowners now face mortgage repayment costs three times higher than what they’ve been paying. The financial stress is very, very real.

Canstar’s database shows the average one-year mortgage rate is currently 7.23%, the average two-year rate is 6.90%, and the average three-year rate is 6.59%.

New Zealanders have generally tended to fix their mortgages for a certain period - most commonly for two years - rather than leaving them on floating rates. But in these circumstances, homeowners will likely also be looking at the shorter- and longer-term rates and trying to figure out what would work best for their finances and lifestyle needs.

So, how do you do it?

At Canstar, we decided to find the “break-even” rate; the interest rate a borrower would need to secure at the end of the initial fixed term to have paid the same amount of interest had they chosen a longer- or shorter-fixed term. This is the figure that can help guide your mortgage-fixing decision.

For our example, we ran the analysis based on the average owner-occupied home loan ($330,856), repaying principal and interest over a 25-year period.

We found:

- Fixing for a one-year term at current average rates, will cost you, on average, $23,761 in interest over the period ($1,980 a month);

- Fixing for a two-year term at current average rates will cost you, on average, $44,971 in interest over the period, or $22,486 each year ($1,874 a month); and

- Fixing for a three-year term at current average rates will cost you, on average, $63,805 in interest over the period, or $21,268 each year ($1,772 a month).

Canstar then figured the “break-even” rate, at which point the interest paid over a certain period would be the same if a mortgage was fixed with two shorter terms, or one longer one. Anything above this point would mean fixing at a longer term at the outset would cost less in interest - and vice versa. In our example, we found:

- If you fix for one year at 7.23%, the second one-year fix will need to be at 6.55% for you to ‘break even’, or for you to pay the same in interest over two one-year terms or one two-year term; and

- If you fix for a two-year term at 6.90% the second one-year fix will need to be 5.93% for you to ‘break even’, or for you to pay the same in interest over a two-year plus one-year term structure than one three-year term.

Remember: anything above these “break even” rates mean you’d be better off taking the longer terms in the first place. Anything below these “break even” means you’d be better off taking two shorter-term rates.

So where do you think rates will sit in one year or two years? And, if you run the numbers on a mortgage amortisation calculator, what is the break-even point which would make a difference for your own mortgage? Answering this will help you make a decision that could save you serious money.

In a time of almost constant flux, this gets us the closest we can to understand how to figure out our mortgage payments, while also creating as much certainty as possible around future costs.

- Jose George is general manager of Canstar New Zealand

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