To fix or not to fix

Central banks have been taking extreme measures to drive down short-term interest, and longer-term bond, rates hoping to stimulate the economy and repair the shaky finances of banks and governments. Although not talked about enough, this is being done at great loss to defensive investors, institutional pension funds and annuity providers worldwide. Other winners are borrowers who are paying a lot less to use other people’s money – that is until asset prices move past fair to over-valued which will hurt new borrower-investors.

In Adam Carr’s recent detailed look at interest and bond rates (What’s going on with fixed rate loans?) he finished concluding that now might be a good time to fix interest rates. I agree, though it makes sense to put into perspective to whom this might be relevant, and when.

Why debt?

It’s worth remembering that there are two sensible reasons for using debt.

1. To fund a roof over your head earlier and cheaper than were you to save to buy it outright.
2. Trying to accelerate wealth building, hoping investment returns exceed the cost of debt

Sadly some people use debt for a third reason: to enjoy, for a short time only, a lifestyle they can’t afford. Since I don’t suspect these people use their borrowed money to subscribe to the Eureka Report, we won’t say any more about them.

Fixing housing debt

Most of the time, borrowing money in Australia on a variable rate is cheaper than at a fixed rate for a fixed term. The extra cost is compensation for the likelihood that interest rates may rise.

Most borrowers think they can guess interest rate movements and decide only to fix when they are more certain rates will rise. However generally the market has built in the probability of a rate rise into the rate differential. A higher margin applies when it’s more likely interest rates will rise and a lower margin exists when it’s likely they won’t.

My advice is usually to disregard your own - and others’ - views on the likelihood of interest rates and instead focus on the affordability of an interest rate rise. If your cash flow can’t afford interest rates to rise say 1-2% with heavy borrowings, then you need to fix some of your debt as a risk management strategy. The extra cost you pay in interest is simply an insurance premium for you to keep your home if rates were to rise.

Unfortunately, unlike in the USA and other parts of the world, banks don’t offer to fix loans much past five or ten years, so this insurance is only for short-term use. On a similar disappointment, my suggestion to the bank to offer a floating until capped interest rate loan product fell on deaf ears. The best answer I could get was to buy, at an uneconomical price, a put or collar that would pay  compensation (before being taxed) should interest rates stray.

The figure below charts average residential-property-secured borrowing rates versus the term of the fixed rate in years. Shown are both the headline rate and the official comparison rate which is based on a $150,000 loan over a 25-year term once fees are factored in. If your loan is larger, then the headline rate is probably a better comparison. I’ve sourced these from ubank’s website in case you want to do your own lender comparison.

Click to enlarge

This chart is essentially saying that for the next three to five years there is no penalty for fixing your borrowing rate. According to theory, ‘Mr Market’ is extremely sceptical that interest rates will rise during this period and is happy for you to have for free an option to not pay more if they do. He is even arguing that interest rates are destined to fall.  

By the way, don’t pay much attention to the 10-year rate - in Australia there is very little demand for 10-year duration non-government bonds, which makes it uncompetitive for a bank to offer a fixed rate for that long. Put another way, I don’t think the market honestly believe interest rates will rise steadily from 5% to 11% over the next 10 years to justify paying a breakeven 8% rate for 10 years.   

It is rare for me to not trust the market, however, I think in the case of short-term rates it’s wrong. I think in fact it is deluded by central bank intervention. Interest rates are “rigged” by central banks. The opposite of not paying enough to depositors, is not charging borrowers enough for the risks of rate rises.

So I think it is entirely reasonable to fix some of your home loan and enjoy this free option.

Be careful fixing all your loan, especially if you might later regret not being able to pay it off with increased savings or perhaps an inheritance. It might be also wise, if it’s not too expensive, to fix say a third of the loan for two to three years and another for five years. If you’re not likely to pay off the variable third component in the short term, then when your first fixed-rate loan expires in two to three years, refix it for five years (when your first five-year loan will mature in two to three years). This will reduce your sensitivity to future rate rises.

Fixing investment debt

The decision to fix the rate of borrowings used for investment purposes is somewhat different in my opinion.

For sophisticated investors with access to lower-taxed ways of investing “owned monies”, or for those who have non-deductible debt, the impetus to pay off principal deductible debt is less. This makes this debt more perpetual in nature – say until retirement when any negative gearing benefit may be lost or the case for or ability to service debt is less. Noting even then, in many cases, debt can be serviced by rising rents or dividends, so paying off debt is optional and sometimes done only because of lack of better rates for cash.

The risk of interest rate rises is also less for higher income borrowers. Under the current tax system if you earn over $180,000 and interest rates rise 1% you own pay 0.535% of that rise – or about half. Like it or not the government considers itself a co-investor with you. It wants a share of your income (and later a share of your gain), but it’s also willing to cut its take if your costs rise. Sorry but it has also taken a share of any interest rate fall you’ve benefitted from.

The first factor argues for fixing some of your debt since you may plan to hold it for a longer term and become more rate exposed. The second factor argues against doing so as your risk of rate rises is cushioned by your unwelcome co-investor.

Other thoughts

The Australian invented, home loan offset account is a wonderful invention - provided you don’t use the offset money as an ATM which is what the banks want you to do. While you should probably confirm with your accountant what sounds like tax advice, I have often wondered if first home buyers should never pay off the principal debt of their first home – just offset it to access another day. Sometimes first home (apartment?) buyers move on to buying a second home and would like to keep their first home as an investment property. If they paid down their mortgage debt then they can’t borrow back the money and claim a tax deduction for it, as the purpose of that money is to buy a non-deductible new home.

Borrowing in super is a compelling way to enlarge your super fund. However, in the case of low yielding residential property, the ongoing income loss doesn’t enjoy much or any tax support because of super’s low tax rate. If you are a high-income earner and you borrow through your super fund, you are worse off each year compared to borrowing in your own name. And you are only made better when you sell and expect to pay less in capital gains. It is possible however that by then you might not be working and not paying much tax. Borrowing in super looked like a poor idea when the previous government was going to tax excess income which included one off capital gains.

(By the way I do like the idea of businesses buying property in super they would otherwise rent from someone else and doing so earlier with borrowings. Doctors and dentists are often the luckiest, as they are able to buy commercial property that often appreciates like residential.)

I haven’t touched on margin lending here, preferring to discuss property-secured borrowings. In my opinion, since margin lenders can easily sell your collateral Monday to Friday between 10am and 4pm they should charge you less, not more. I don’t like margin lending for that reason and because at the worst of times it can make you a forced seller - which is one of the few ways to really lose money when markets inevitably reverse. Maybe Mark Twain was thinking about margin lenders when he said “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”.

Don’t ever repeat the mistakes of Storm Financial clients and borrow against your home and gear that equity up with a margin loan. The only trick they didn’t think about then was to invest into an intrinsically geared fund (example  http://www.colonialfirststate.com.au/prospects/FS1126.pdf ) to be triply geared and hyper-sensitive to market movements.  

In summary

Australia’s high house prices demand that most people become highly indentured workers for a decade or more of their lives. Especially during the early years where your debt is more than three times your income or your debt-to-assets is more than one-third, fixing some of that debt is a reasonable risk management strategy. At the moment the usual insurance premium for doing so seems to be nil.

Borrowing to accelerate the growth of wealth is a reasonable strategy for some people, but also for many entirely unnecessary. My long-term studies of interest rates and share-market returns suggest about 80% of the time you’ll cover your costs doing so if you have a 10-year horizon, but there remains a one-in-five chance you won’t. I guess with interest rates at unusually low levels, your odds are better. However with asset prices having moved past cheap (I last talked about this in October 2012 - The end of negative gearing), your odds are worse. For most people making money doesn’t need to be a coin toss, so there is nothing wrong with passing on that game.

Dr Douglas Turek is principal advisor with family wealth advisory firm Professional Wealth (www.professionalweath.com.au)