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As the Reserve Bank eyes the possibility of further rises in interest rates, John Kavanagh examines the pros and cons of fixing a home-loan rate.
Interest rates on a number of fixed-rate home loans are currently lower than the variable rates of about 7.4 per cent that are being offered by many lenders.
With the prospect that interest rates will go higher over the next 18 months, the question of whether to fix all or some of the borrowing should be accorded serious consideration.
With signs of mortgage stress growing, borrowers need to make sure they are taking every opportunity to manage their debt burden efficiently.
Right now the best opportunity may lie in taking advantage of highly competitive fixed rates.
The financial services analyst for Infochoice, David Lalich, says most of the changes are to two- and three-year rates.
Sharer...Jacqui Booth. Photo: Stuart Quinn
The best two-year fixed rates are below 7.2 per cent, which is competitive with a number of lenders' variable rates. The most competitive are RAMS, the Bank of Queensland, HSBC, Nationwide Mortgage and Commonwealth Bank.
Borrowers can have three-year rates below 7.5 per cent from RAMS, Heritage Building Society, Westpac, National Australia Bank, Better Option Home Loans and Greater Building Society.
Fixed-rate loans usually cost more than variable rates because the borrower is paying a premium for certainty.
It is like an insurance policy, whereby the borrower pays the bank for taking over the interest rate risk.
At the moment, that premium is very low, which reduces the chances of becoming locked into a rate that could very well become unattractive a couple of years down the track.
Part of the fixed-or-variable debate has to be a consideration of where interest rates are headed.
The Reserve Bank's decision to hold off on a rate rise this month, combined with concerns that the European sovereign debt crisis is the beginning of GFC II, might lead people to think that the Reserve has taken further rate increases off its agenda.
Bank economists say it would be a mistake to think that way. All of them are forecasting higher rates later this year and throughout 2011.
ANZ forecasts that the official cash rate will rise from its current level of 4.5 per cent to 4.75 per cent in the September quarter and then to 5 per cent by the end of the year.
It expects the Reserve to have pushed cash rates to 5.5 per cent by June next year. Westpac's latest forecast is for the cash rate to hit 5 per cent by the end of the year and to reach 5.5 per cent by September next year.
The Commonwealth Bank is more bearish. It expects the cash rate to be 5 per cent by the end of the year and 6 per cent by the end of 2011. Its view is that the strength of the Asian economy is the real determining factor for Australian monetary policy, not what is happening in Europe.
The National Australia Bank has a similar view. It is forecasting a cash rate of 5.25 per cent by the end of the year and 6 per cent by the end of 2011.
Its latest commentary says: "The key driver of our upward forecast is the additional income generated by sharply higher forecasts for the terms of trade - up 18 per cent over 2010. That, in turn, flows over into additional investment, profits and consumption."
Mortgage market data from a number of sources over the past couple of weeks shows an increase in the take-up of fixed-rate home loans.
Such loans made up 3.26 per cent of the Mortgage Choice approvals in May, compared with 1.77 per cent in April.
The Australian Bureau of Statistics' housing finance data shows fixed-rate loans dropped from a peak of 8 per cent of all dwellings financed in June last year to a low of 2.1 per cent in February and March. There was a pick-up to 2.4 per cent in April.
The head of macro markets at AMP Capital Investors, Simon Warner, says fixed-rate loans are at attractive levels: "Some of them are lower now than when the Reserve Bank started putting rates up last year. This is definitely an opportunity for borrowers," he says.
"It is hard to see them going any lower than they are now. Some big economic issue would have to come into play for that to happen. If I were a risk-averse borrower, I would be locking in."
Most borrowers do take a risk-averse approach to their borrowings.
The deputy governor of the Reserve Bank, Ric Battellino, said in a speech in Sydney this month that half of all home loan borrowers have been ahead of schedule on loan repayments in recent months.
He says the current arrears rate on home loans is 0.7 per cent, which has increased over the past couple of years but is one of the lowest levels of non-performing loans among the developed economies.
However, there is also plenty of evidence that borrowers are getting into trouble.
Westpac reported in May that the number of mortgage customers in its hardship assistance program (people who have approached the bank to have their repayment terms varied because they are in financial difficulty) had doubled since September.
According to the most recent Fujitsu Consulting Mortgage Stress-O-Meter, released in March, the number of severely stressed households (those facing a forced sale) has risen this year as a result of higher interest rates.
Borrowers tend to shy away from fixed rates for several reasons. They are inflexible, providing no opportunity for additional repayments, offsets or redraws.
Borrowers risk being locked into a rate that ends up being higher than the variable rate if rates start to fall; and if borrowers want to get out of a fixed-rate loan they are required to pay high break costs. Break fees are set as a percentage of the loan amount or several months' interest payments. Whichever way they are calculated, they can cost thousands of dollars.
The Reserve has reported that bank-fee income on home loans increased by 17 per cent last year. In its report on fees, the Reserve says: "The available information suggests that break fees on fixed-rate loans accounted for a significant proportion of the overall growth in fees."
One lender is hoping to offer the best of both worlds with the launch of a capped-rate loan.
Opportune Home Loans has a loan with a starting rate of 7.04 per cent and a cap of 7.49 per cent for the first two years. The managing director of Opportune, Paul Ryan, says borrowers are put off fixed-rate loans because they are inflexible. "A capped-rate loan gives borrowers that flexibility with some security," he says.
KEEPING IT ALL IN THE FAMILY MAKES SENSE
Jacqui and Anthony Booth both work in the property industry and, although only in their 20s, have long had a shared interest in property investment.
So it made sense to the brother and sister from Newcastle to pool their resources and apply jointly for a loan to buy their first property.
In March they settled on a four-bedroom house in Cardiff, in the Lake Macquarie district near Newcastle, and set up a shared house with a couple of friends. They had a 10 per cent deposit and borrowed from Bankwest, through a Mortgage Choice broker.
"No one thought it was strange that my brother and I were going into this together," Jacqui says. "Lots of people my age want to get into the market but they can't get in. It is too expensive. The thing people have been saying to us is that they would like to have someone to buy with."
According to a Mortgage Choice home buyer survey, conducted earlier this year, 3 per cent of first home buyers entered into a co-operative arrangement with a family member, friend or work colleague to buy a property. Two per cent used a gift from parents or had their parents act as guarantor.
Anthony, 28, is a quantity surveyor and Jacqui, 24, prepares depreciation schedules for property investors.
Neither is married but they have talked about how they will handle things when one or the other needs a family home.
Jacqui says: "We have an agreement so that things don't get messy when either of us gets married. We see this as the first of a number of properties in a portfolio. We will definitely be buying one more."
Stress test your home loan
Banks and other financial institutions are subjected to stress tests by their regulators every year or so to make sure they are in good shape to handle sudden downturns in economic and market conditions.
Why not apply stress tests to consumers, so they could get a picture of how interest rate rises, falling asset values or loss of income would affect them?
This proposal was put to last year's Parliamentary Joint Committee of Corporations and Financial Services inquiry into financial products and services, the Ripoll inquiry, by the Institute of Actuaries (IAA), which argued that personal stress tests should be compulsory for anyone entering into a major financial commitment.
A former president of the IAA and co-author of the Ripoll submission, Geoff Burgess, says the two main problems people face when they make financial commitments are borrowing too heavily and investing where there is insufficient diversification. Another problem is loss of income.
"What we proposed was a uniform set of scenarios, to be devised by a regulator such as the Australian Securities and Investments Commission, that would show people the financial outcomes of interest rates going up, asset prices falling and so on," he says.
Lenders usually look at how borrowers would cope with interest rates up 2 percentage points but interest rates have risen 1.5 percentage points since October and may go up that much again by the end of 2011.
A stress test would study the effect of a bigger rise — maybe 3 or 4 percentage points. When asset values are falling, lenders may require extra security or cash if maximum loan-to-valuation ratios are breached.