To fix or not to fix ... is that the question?

Pardon my variation on Shakespeare but the impact of the latest increase in interest rates, and what to do about it, is on many of our lips at present.

After meeting on Melbourne Cup Day, the board of the Reserve Bank of Australia announced on 7 November another 0.25% increase in official rates. So is it much ado about nothing or hubble, bubble, toil and trouble? 

The statement by the RBA governor, Glenn Stevens, on monetary policy included:

"During 2007, the pace of growth of demand and output has also increased. There are few signs of that strength diminishing as yet, and reports of high capacity usage and shortages of suitable labour persist. Growth in labour costs has been contained so far, and high levels of investment are adding to productive capacity in some sectors. The rise in the exchange rate will help to contain pressure on prices. But growth in aggregate demand will, nonetheless, need to moderate if inflation is to be kept to 2-3 per cent in the medium term."

Yes, the RBA is concerned by the current rate of inflation, the management of which is their primary obligation under their charter. Therefore the RBA board is closely watching rising costs and our overall level of debt, particularly consumer debt as excessive private consumption is a clear contributor to inflationary pressures. However, not all debt is bad as loans for business and personal investment contribute to long term wealth and national prosperity.

Just 12 months ago, the 'standard' bank variable interest rate was 7.82%. It will soon be 8.57% reflecting 3 rate rises of 0.25% including the latest rise.

However, fixed rates have risen by over 1.00% over that same time, from late 6%’s to early 7%'s for 3 -5 years to now mid 7%'s to 8.00+%.

As an aside, there is additional speculation that our local banks and lenders will be forced to further raise rates as a result if the US sub-prime loan crisis.

The increase in the cost of funds to our lenders is real and some mortgage managers and wholesale lenders have already adjusted their rates and/ or their product offerings to reflect this. Our mainstream lenders, particularly the top 6 banks, with the biggest balance sheets and media profiles, are currently absorbing these costs in their interest spreads and profit margins.

Therefore a separate rate rise could be technically justified although whether any of us are overly concerned over what profit margins lenders make is another matter. However, the real question for our major home loan lenders, in particular, is which one would be bold enough to make the first move?

To use some horse racing parlance, there's been lots of stomping and snorting from lenders through a number of public pronouncements in this regard while they all jockey for position. Interestingly, there are no government or market barriers to stop lenders from raising their rates outside of RBA cash rate decisions, except one and that is the inevitable public and no doubt political whipping.

And any hint of collusion between lenders, whether real or imagined, would also be harshly dealt with so they are caught against the rails on this one.

My guess is they will continue to ride a very controlled race for now on a pretty heavy track. Will one horse be soon forced to break from the pack? If they lead will others follow quickly, or ease back and watch the leader get flogged?

If you can predict this race plan you will be on a very handy trifecta indeed!

Watch this space ... or is that race?!

(By the way... I expect that business rates will increase as these receive less scrutiny.)

Now, back to the question of fixing your home or investment loans.

For home owners, in particular, reducing debt and being concerned over rising interest rates is understandable but also underscores the need for advice.

However, for investors, a focus on debt reduction or the distraction of an interest rate rise are not the main issues. I don't say this because investors aren't affected by higher rates, obviously they are, but interest cost is only one factor in an investor's overall investment strategy.

Whilst managing rate risk is a responsible aspect of any investment strategy – see my comments on interest rates below – the more fundamental questions are, “Do I buy or invest at all?”, “How do I manage the risk of owning assets?” and then, “How do I manage the debt and rate risk of my geared assets?”

Many of our clients will recall one of my personal investment truisms when discussing their fear of risk, i.e. “The biggest risk you can take is not to do something and fail, but it is to do nothing and achieve exactly that.”

Many of us prefer to avoid debt, thinking that’s ‘safe’, and yet, given the chance, very few us would think twice about borrowing to buy a home. The reason is that a house satisfies our basic need for shelter but there is also the underlying expectation that the value of our home will increase over time.

These are tenets of our Australian way of life, and shared by many countries around the world. They have been proven over generations and centuries.

Therefore, we are sufficiently confident to buy a home and borrow long term to do so despite the ‘risks’ of property cycles, interest rates, government policies, economic conditions, job opportunities, taxation, cost of living, heath, etc.

However, many of us also shudder at the prospect of borrowing money to buy property (or shares) in exactly the same market and with the same risks. This is despite that, with good advice, these investment assets will likely perform far better than our homes. We’re a weird lot, aren’t we?!

For example, common sources of 'advice' for home buyers is a family member, friend, workmate or even the estate agent. This is the norm and quite accepted practice. However, investors can access experienced and professional advice on every single aspect of their investment strategy.

Obviously, our thinking is perverse and sound investing and gearing can be much less risky than borrowing for a home, yet not enough of us do it.

Other aspects of a sound investment strategy should include advice on asset structuring, tax planning, personal risk insurance and estate planning. All that might sound a bit complex and daunting but, again, professional advice will take care of these issues and give you greater confidence and peace of mind.

In summary, seek the very best advice available rather than trust yourself or plain luck. Sure, you will pay for good advice but that will certainly be much less than the cost of your mistakes and/ or the loss of good opportunities.

Now, back to interest rates and what you can do to pro-actively manage this part of your home or investment loan strategy. The short answer is this.

The best reason to fix a rate, at any time of the economic cycle, is not to try to pick the lowest rate but to lock-in your cost of funds. This means you will have one less variable (pardon the pun) in your overall investment strategy that you have to think about for a set number of years.

As noted above, at the time of writing, 1 – 5 year fixed rates are at or a little above 8.00% and well below the new ‘standard’ variable rate of 8.57% pa.

Some lenders have already responded to the market and announced increases to many/ all of their fixed rates and I expect more to follow.

However, most borrowers are eligible for attractive interest discounts or loan 'packages' on standard variable rates of 0.70%, i.e. around 7.87% pa (new rate). Therefore, there's still only a small premium, if any, to pay to fix some or all of your loans. (Minor discounts on fixed rate loans can also be obtained but only from one or two lenders as the profit margins on these are lower.)

The above would suggest it's best to fix some or all of your loans now. Easy! However, this assumes that you don’t expect rates to fall again during the fixed rate term otherwise you might end up paying above market later on.

As an extra factor, some borrowers/ brokers can negotiate even higher variable rate discounts due to the size and value of their loan portfolio.

See, it’s not that simple.

Beyond that, there are even more considerations to take into account:

• Might you want to sell property in the foreseeable future?
• Might you want to repay the loan in part or full during the fixed term?
• Might you want to make extra repayments during the fixed term?
• Might you want to refinance during the fixed rate term?
• Do you have a safety buffer built into your finance structure?

All these issues, and more, may affect you decision to fix your rate.

However, the biggest part of your decision regarding interest rates, now or in the future, is much less about the prevailing conditions and much more about your attitude and mindset. If you base your decisions on fear then you will feel unsettled irrespective of your decision or the outcome.

If you’ve not planned your investment strategy to date but ‘flown by the seat of your pants’ then you are much more likely to suffer from the ‘slings and arrows’ of the market and react more nervously to media hype and headlines.

However, if you have good investment assets, which should perform at or above average in the medium to long term and good advice, then whatever your decision, you will very likely ride out the vagaries of the market.

It’s about being pro-active in every aspect of your strategy and regularly reviewing it and your related options. It makes real sense … and money.

When was the last time you reviewed your investment strategy and finance structure? Given the current conditions, and the speculation of further rate rises in 2008, now might be an ideal opportunity. You can even guarantee your fixed rate on settlement/ draw down by paying a "rate lock" fee now.

What's right for you? Give your bank, or better still, your broker a call.

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