A borrowing strategy to consider

Borrowers need to be attuned to the risk of higher interest rates early next year if the Reserve Bank delivers on its warning, ANZ economists say.

Wednesday, December 20th 2006, 11:03PM

Lower interest rates are a long way off. In this environment, locking in longer-term rates now, despite the lack of flexibility, is looking increasingly attractive.

Although the Reserve Bank left rates unchanged in December, its tone was more hawkish than expected. This saw the wholesale interest rate curve move up, which has flowed through into the mortgage curve.

The door to a rate hike in January is now open with the wholesale market pricing in a 90% chance of a 25 basis point increase by March next year.

If the Reserve Bank does deliver a hike, the risk is that there could be another one on the cards.

What to do?

With the one-year carded mortgage rate close to 8.5% and the two-year rate closing in on 8.2%, the 3 to 5 year end is looking increasingly attractive, particularly as the chances of interest rates coming down over the next 12 months look slim.

Floating rates look unappealing as they will be the first to rise if the Reserve Bank does increase interest rates, but may continue to appeal to those who intend to pay it off quickly.

Fixing for longer periods provide a degree of certainty in terms of repayments, but lacks the flexibility to take advantage of lower interest rates when and if that eventually occurs. However, given that the prospects for lower interest rates are a long way off, this may not seem that big a disadvantage at this stage.

Going Forward
A further interest rate hike by the Reserve Bank is looking like a 50:50 call although this is not ANZ's central view at this stage. Its quantitative forecasts are not showing it, we have to acknowledge the qualitative risk profile, which points to the current period of monetary policy restrictiveness being extended for a considerable period in the absence of a major event or development.

Themes ANZ recommend

Take a balanced (diversified) approach. We continue to favour a balanced approach to spread your risk by having exposure to different parts of the yield curve.
Longer-dated (3 to 5-year) rates still offer some value given their historical average, the risk profile for rates and the prospect for an elongated period of higher interest rates. Ultimately it all depends on the individual circumstances but locking in now avoids the risk of facing higher interest rates early next year.
Take an 18-24 month rate now, in anticipation of more favourable 2-year rates in 2008. A succession of shorter-term rates could leave you better off over five years than taking a five year rate by the time the loan comes up for renewal. This approach is consistent with our core economic view that rates are set to fall aggressively from late- 2007/early 2008. Those bearish the property market should be hedging here.
If cash-flow is an active constraint, look at extending the term of the loan. While this means paying more in interest costs, at least it provides some cash-flow relief in the near-term.

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