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To fix home loan interest rate or not?

16 Jul 2014

For many homeowners already hard-pressed to manage the rising costs of living, the prospect of another interest rate hike is not a pleasant thought, and some may be wondering whether now is a good time to fix their home loan interest rate, while it is still low.

Most people only think about fixing their rate when interest rates start rising which is not always when they will get the best deals, says John Loos, Household and Property Sector Strategist at FNB Home Loans.

Most people only think about fixing their rate when interest rates start rising which is not always when they will get the best deals, says John Loos, Household and Property Sector Strategist at FNB Home Loans.

On Thursday the Reserve Bank’s (SARB) Monetary Policy Committee (MPC) will announce whether there will be a further interest rate hike at this stage. After the last surprise rate hike, some economists have recently speculated that there might only be one more increase this year in November of 0.25%, but according to the latest FNB Property Barometer a hike of 0.25% in the repo rate is expected tomorrow, taking it to 5.75%.

This will mean the prime interest rate for home loans will move slightly up to 9.25%.

Writing in the FNB Property Barometer, Loos says FNB forecasts further mild interest rate hiking with the prime rate expected to reach 9.75% by the end of the year and 10.25% by the end of 2015, as the SARB gradually attempts to normalise interest rate levels. He points out that this is after a long period of abnormally low interest rates brought about by an abnormal global economic crisis around 2008.

So what should a homeowner consider before fixing their rate?

Loos says many people try to base their decision on whether they think they can "beat the market" or not.  However, we live in an uncertain world and this approach can lead to faulty decision making, and even those supposedly in the know can get it wrong.

Fixed interest rates are a tool offered precisely because of future uncertainty and the purpose of fixing rates should be for greater cash flow certainty, says Loos.

Fixed rates allow bond holders to, for a certain period, shift the cash flow risk involved with fluctuating interest rates onto the bank, explains Loos. "The bank assumes and manages the interest rate risk, and the client obtains certainty over the interest rate payment portion of their cash flows."

However, the homeowner will have to pay a price for the benefit of fixing their rate.

Should floating rates over the period of fixing average a rate lower than the level of the fixed interest rate for the period, then the homeowner would have been better off, only with hindsight of course, leaving their interest rate to float, says Loos.

Conversely, Loos says if the SARB were to “shock us” with interest rate hiking, and the average floating rate over the period is significantly higher than the bond holder's average fixed rate, then the homeowner "will thank his lucky stars" that he fixed his interest rate at the beginning of the period.

Ultimately, Loos says the decision to fix or float should rest on how much certainty one would like over one’s cash flow. For those who wish to avoid risk, even if floating rates should average a lower rate over a specific period than the average fixed rate that they fixed at, the value is in having cash flow certainty under a fixed rate arrangement for a defined period - be it one or two years or even perhaps five years, he says.

"This can allow such people to sleep more peacefully at night, and thus be worth its weight in gold for that particular period regardless of which way interest rates move."

When considering whether to fix or not, Loos says homeowners should answer these questions:

  1. What is your appetite for risk? Does it cause you major stress? If so, perhaps you lean naturally towards fixing.
  2. How “close to the edge” are you financially? If your overall financial situation gives you very little leeway to absorb any nasty shocks, you may also lean towards fixing rates.

When to fix rates?

For many, when the SARB starts to hike rates may seem like the ideal time to fix their rate in the expectation of more to come.

There’s a catch though, says Loos, as when a bond holder fixes his interest rates, a bank takes over the risk of interest rate fluctuations from its client. "The bank in turn will then hedge out its own risk by offloading the client’s floating rate debt in exchange for a fixed rate debt instrument (negotiable certificates of deposit or bankers acceptances for example) in what is called a swap, for the duration of the fixed rate term that the bank has offered its client (in practice this gets done in bulk deals by the bank’s treasury division). "

The price and interest rates at which banks can obtain such fixed interest debt instruments, and thus the fixed rate which they can offer their clients, is determined by future interest rate expectations of the market, explains Loos.

He says if the market expects more interest rate hikes during a SARB hiking phase, then the rate which the banks can pass on to their client can appear somewhat unattractive.

"The converse also holds true, i.e. that fixed rates on offer start becoming more attractive when market expectation of future interest rates has moved lower, and can remain fairly attractive during periods where interest rates have reached the bottom of a cycle (always impossible to know for sure if that stage has been reached) but the market doesn’t yet expect interest rate hiking for a significant time period."

Therefore, the decision to fix interest rates or not depends on considerations such as an individual's appetite for risk or their own financial position, says Loos.

However, he points out it is often in times of interest rate cutting or in periods of low sideways movement in interest rates, prior to widespread expectation of imminent rate hikes, that the better fixed rate deals are probably going to be found.

Other ways of gaining certainty over your cash flow

There are other  ways to safeguard your cash flow and Loos says it would be wise to consider these options:

1. Set monthly payments well above the required payment

For those looking at buying property, he says a great way to increase certainty regarding repayment cash flows is by living well within one's means by buying significantly cheaper than one's financial limits allow.

Loos says many bonds have no penalties for early settlement so homeowners would then be able to set the monthly repayment significantly above the required monthly payment, which would imply that up until a certain magnitude of rate hikes one’s monthly payments would not change, thereby improving cash flow certainty.

"For example, if one has a bond to the value of R700 000 at prime rate (currently 9%), setting the monthly instalment value at R9 477, instead of the required R6 298, would mean that one’s instalment value would not be required to change unless prime rate rose to above 15.5%. "

This should provide very significant cash flow stability with regard to bond repayments, he says.

He says the prime rate rose by 4 percentage points to 17% in 2002 and by 5 percentage points to 15.5% in 2008, so although it's impossible to predict exactly what will happen, the past two interest rate hiking cycles can be used as a benchmark.

2. Raising your instalment annually in line with annual wage inflation

The second alternative is to start one’s instalment at the required rate, and raise it annually by a certain percentage, for instance by one’s annual wage increase percentage or by the CPI (Consumer Price Index) inflation rate, says Loos.

"This would mean that, as the years go by, one would gradually adjust one’s lifestyle to a higher bond repayment, and hopefully also gradually reduce one’s exposure to unwanted cash flow shocks created by interest rate hiking."

Loos says the key lesson to be learnt, though, is that building one’s financial buffers should be an ongoing process, not merely ignored until such time as it appears that a financial shock may be on its way, or only when interest rates start to rise.

By then it is usually too late, and one has missed out on the ideal period in which to build one’s defenses - during times of low interest rates, he says.

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