Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

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Invest in Sydney/Brisbane property markets, or for media/public speaking requests, email pete@allenwargent.com

Monday, 12 November 2012

3 different ways of looking at fixed mortgage rates

Where are interest rates now and where are they headed?
Ask a dozen different commentators and you will get a dozen different answers, of course, but today’s cash rate is 3.25% and it is generally acknowledged that we may not yet be at the end of the easing cycle.
While I tend to retain a more positive outlook on interest rates and on life, the implied yield curve suggests that interest rates could have a little way to fall yet, perhaps dropping to 2.75%, before flattening and then recovering.


Recent interest rate history
To put the above in context, one further 25bps cut in the cash rate to 3.00% would see interest rates at half-century lows.
Yet it’s not so very long ago that interest rates were at nosebleed levels of above 15% as the data in the table I’ve compiled for you below shows:
Date
Change in cash rate (%)
Cash rate (%)
2/10/2012
-0.25
3.25
5/06/2012
-0.25
3.50
1/05/2012
-0.50
3.75
6/12/2011
-0.25
4.25
1/11/2011
-0.25
4.50
3/11/2010
0.25
4.75
5/05/2010
0.25
4.50
7/04/2010
0.25
4.25
3/03/2010
0.25
4.00
2/12/2009
0.25
3.75
4/11/2009
0.25
3.50
7/10/2009
0.25
3.25
8/04/2009
-0.25
3.00
4/02/2009
-1.00
3.25
3/12/2008
-1.00
4.25
5/11/2008
-0.75
5.25
8/10/2008
-1.00
6.00
3/09/2008
-0.25
7.00
5/03/2008
0.25
7.25
6/02/2008
0.25
7.00
7/11/2007
0.25
6.75
8/08/2007
0.25
6.50
8/11/2006
0.25
6.25
2/08/2006
0.25
6.00
3/05/2006
0.25
5.75
2/03/2005
0.25
5.50
3/12/2003
0.25
5.25
5/11/2003
0.25
5.00
5/06/2002
0.25
4.75
8/05/2002
0.25
4.50
5/12/2001
-0.25
4.25
3/10/2001
-0.25
4.50
5/09/2001
-0.25
4.75
4/04/2001
-0.50
5.00
7/03/2001
-0.25
5.50
7/02/2001
-0.50
5.75
2/08/2000
0.25
6.25
3/05/2000
0.25
6.00
5/04/2000
0.25
5.75
2/02/2000
0.50
5.50
3/11/1999
0.25
5.00
2/12/1998
-0.25
4.75
30/07/1997
-0.50
5.00
23/05/1997
-0.50
5.50
11/12/1996
-0.50
6.00
6/11/1996
-0.50
6.50
31/07/1996
-0.50
7.00
14/12/1994
1.00
7.50
24/10/1994
1.00
6.50
17/08/1994
0.75
5.50
30/07/1993
-0.50
4.75
23/03/1993
-0.50
5.25
8/07/1992
-0.75
5.75
6/05/1992
-1.00
6.50
8/01/1992
-1.00
7.50
6/11/1991
-1.00
8.50
3/09/1991
-1.00
9.50
16/05/1991
-1.00
10.50
4/04/1991
-0.50
11.50
18/12/1990
-1.00
12.00
15/10/1990
-1.00
13.00
2/08/1990
-1.00
14.00
4/04/1990
-2.50
15.00-15.50
15/02/1990
-0.50
16.50-17.00
23/01/1990
-1.50
17.00-17.50


What this table demonstrates is that, while high interest rates may be perceived to be an idle threat today, there is definitely a place for fixed mortgage rates as protection from very high rates of interest.
While many argue that it is better simply to roll with the punches and accept a variable mortgage rate, I prefer to have a mixture of fixed and variable rates in my portfolio.
A structural shift?
There is an argument to suggest that there has been a structural shift towards lower inflation and lower interest rates since 1990.
While it is not possible to see the future with any certainty, what is certainly the case is that interest rates have fallen lower without Australia even succumbing to a recession.
Here are 3 different ways to look at fixed interest rates:
1 - Fixed rates as an insurance policy
If you pay your car insurance policy for the year and don’t have to claim on the policy, are you happy or annoyed? Well, you could argue that one either way, but as a general rule, you should be happy because this means you have avoided having a serious accident.
Insurance policy payments are known as premiums. Sometimes, there can be a premium for fixing a mortgage rate, particularly when interest rates are climbing. Smart investors recognise that the premium is effectively a form of insurance against adverse movements in rates.
2 - Fixed interest rates as a budgeting tool
Fixed interest rates give property owners certainty of cash-flow, which makes budgeting and maintaining a cash buffer far more straightforward than it is with variable rate mortgages.
3 - Fixed interest rates as a hedging instrument
Gold mining companies are currently buying put options which will give them the right, but not the obligation, to sell gold at somewhere close to today’s prevailing gold spot price of around 1,700USD/oz in the future.
Using derivative instruments in this manner is known as hedging and all smart resources companies use the strategy.
What if the gold price spirals upwards and the options become worthless before closing ‘out of the money’? Would the board reprimand the executive or management for wasting cash?
On the contrary, then the gold mining company would be delighted, for they can sell their gold at even higher prices on the open market. The cash outlay on the hedging instrument is correctly recognised by management as a form of insurance expense.
It is common to hear investors say they have been “burned” or “ripped off” by taking out a fixed mortgage rate but why not...
See things differently?
I try to look at fixed mortgage rates in a different manner.
If I fix a rate and the variable mortgage rate falls, I prefer to look at the positives – property prices are likely to climb and I am more likely to receive a great variable rate at the end of the fixed term.
I have one 5-year-fixed mortgage rate in my portfolio at 7.25%, which at the time everyone I spoke to agreed was a fabulous deal. At the time of writing, variable mortgage rates are closer to 6%.
Today, of course, the world is awash with smarty-pants commentators who apparently knew that interest rates would drop sharply due first to the subprime crisis and then again following what appears to have been a dead-cat bounce in the cash rate.
Even if people did foresee the subprime crisis coming, you can be assured that nobody was certain about the timing. In fact, guess how many people I spoke to half a decade ago correctly predicted the chain of events that would lead to today’s 3.25% cash rate?
I think you know the answer to that one!