Fixed or floating, how do I decide?

7 October 2016

Your friend is bragging that she just got a floating rate mortgage and she reckons her payments will decrease soon. Is that right? Should you get a fixed rate or floating rate mortgage? There is more to choosing a mortgage than just finding the cheapest rate available.

What is a fixed rate

With a fixed rate mortgage, the interest rate you agree to pay remains constant for a determined amount of time i.e. you may fix with your bank for a two year period at 4.35%. For the two year period you will pay an exact amount per payment off your mortgage.

Most major New Zealand banks offer a range of fixes between 6 months and 5 years, with a few banks offering 7 or 10 year products. This means your interest rate (and your payment amount) stay the same regardless of what is happening in the economy. At the end of your fixed term you can take up a new deal with the bank or switch to a floating rate mortgage.

Fixed rates are best when interest rates go up because your payments remain the same.

 

What is a floating rate

With a floating rate mortgage, the interest rate you agree to pay can move in line with general economic conditions i.e. at the time of the contract you will agree to pay 5.3% but if interest rates went up you may be required to payer a higher interest rate. If the market changes and rates go up your bank would notifiy you to advise that the rate you are paying has increased or vice versa.

Floating rates move in line with the Overnight Cash Rate (OCR) set by the Reserver Bank and with general market conditions.

A floating rate or variable mortgage does not have a term and you can pay off lump sums without penalty. In New Zealand you pay for this flexibility as floating rate mortgage rates are considerably higher than fixed rates.

 

Let's do the numbers

Let’s say your friend’s floating rate mortgage is for $300,000 with 30 years to maturity. The floating rate set by her lender at the time of the loan was 5.5% meaning her fortnightly payments would be $786.

 

A decrease in the floating rate of 0.25% would decrease her fortnightly payments to $764.

An increase in the floating rate of 0.25% would increase her fortnightly payments to $808.

 

Alternatively, a 5-year fixed rate of 5.30% would have a constant fortnightly repayment of $769 for the next 5 years.

So while there is an opportunity to make savings, there is also a chance that payments will increase. This needs to be considered alongside the certainty you gain from a fixed rate where you know exactly what you will have to pay regardless of what happens to the economy.

 

Pros and Cons

Fixed rate mortgage

Pros

Certainty: you know your exact payment obligations for the life of the fix. This allows you to budget as knowing the exact payment amount makes financial planning easier. If you have a fixed income you can plan for a portion of this to be used for mortgage payments.

Safeguard: If you think an interest rate is favourable then you can lock it in for a set period of time.

Limit: your payments will not increase unexpectedly for the life of the fix.

Cons

Early payment penalties: this type of loan does not allow lump sum / early payments so you would need to restructure your loan if you wanted to make an extra payment. There is a fee for doing this.

No potential for lower payments: if rates decrease your payments will remain the same.

 

Floating rate mortgage

Pros

Potential for lower payments: payments might decrease if interest rates decrease.

Flexibility: you can make early or lump sum payments without penalty. If rates do go down, then you might use the money you have leftover to make an extra payment. If rates go up and you come into some extra funds, you might make a lump sum payment to reduce the size of your mortgage and the amount of interest paid.

Cons

Risk: payments might increase if interest rates increase.

Uncertainty: not knowing your payment obligations can make planning for the future difficult.

 

Are there other options?

Some banks offer a capped rate. That is, the interest rate is floating but there is a ‘cap’ or limit to how much it can go up. This protects you from large rate increases. Typically a provider of these loans would charge a premium for the loan or have conditions that must be met like a high equity ratio.

 

Fixed v floating summary

Professional Advice

The salesperson who sells you a loan should be able to offer advice about which product you should choose and why it is a good fit to your finances.

Understand your financial situation

The decision about which is right for you depends on your income and ability to absorb changes to your payments. You should also consider your appetite for the uncertainty, are you the type of person that will worry about the possibility of rates going up?

Consider a mix

Finally you should also consider splitting your loan and have a portion fixed and a portion floating, thus gaining the best of both worlds. This is particularly useful if you are expecting a lump sum in the near future but are not sure exactly when.