How to handle interest rates in today's changing times

If you're thinking of borrowing or refinancing, this article should be of interest and assistance to you.

Reserve Bank – New Loan-to-Value Ratios
The latest moves by the Reserve Bank should have come as no surprise. Reserve Bank Governor, Graeme Wheeler, was concerned the Auckland property market was entering bubble territory and like all bubbles do, feared it had a potential to burst. If this was to occur, it could shake the financial stability of our monetary system. In an attempt to ensure the system he was charged with remained relatively stable, Mr Wheeler introduced new loan-to-value ratio (LVR) policies. 

Such policy rules were to apply from 1 October and would see property investors in Auckland able to borrow no more than 70% of the purchase price of the investment property they wanted to buy. To stop a frenzy of buying before D-Day, the Reserve Bank encouraged all the major banks to implement the new policy prior to 1 October 2015. Although the date these rules come into force has now been changed to 1 November, most banks have already complied.

Many have critiqued the Reserve Bank's policy setting, citing the Governor has overstepped his mark in making such policies. Criticism has been levelled on constitutional grounds: a non-elected body is making policy which impacts on investment choices available to investors through inhibiting borrowing capabilities. Others, however, have said Mr Wheeler waited to the last possible moment in the hope that Government would regulate the property market and consequently aid financial stability by addressing tax preferred status of housing, especially investor related housing. His advocates noted he introduced his policies only when he believed he had no choice if financial stability was to be achieved in the wake of a property bubble bursting.

Irrespective of what camp you subscribe to, has the introduction of the LVR policies gone some way to achieving greater financial stability by cooling the Auckland property market? Not from my research. It appears loan brokers and banks have been flat-out writing loans.

The policies have, however, had a positive spin-off effect in the regions. Property prices in geographical areas outside of Auckland have enjoyed increases as Auckland investors have flocked to the regions in an effort to use their equity and play by lower LVR rules. Dominick Stephens, Westpac Economist, Tony Alexander, BNZ Economist, and Jonno Ingerson, Core Logic Research Director, all provide data on the relatively recent increases in property values experienced in areas such as Bay of Plenty, Wellington, Waikato and Christchurch. Short run, property prices are expected to continue to increase in these areas  But this doesn't mean Auckland property prices will suffer. I personally believe Auckland prices will continue to rise and it won't be until supply has caught up with demand and an equilibrium is established, whether through increased supply via new builds and intensification under the Auckland Unitary Plan or decreased demand possibly through migration, that prices will slow down somewhat.

Government – New Legislation Introduced
Meanwhile, a little after the introduction of the new LVRs, the Government introduced the bright-line test, effective from 1 October 2015. Under this piece of legislation, it's assumed anyone selling an investment property within two years of purchasing will possess an intention to make profit and will therefore be liable for income tax on capital gains made over that period. There are some exemptions applicable to the rule in relation to personal homes, inherited property and property via personal property relationship demises. Matthew Gilligan wrote an excellent blog on the bright-line rule .

Will the bright-line test curb property buying and selling? Probably not, in my opinion. The majority of people who have an intention to make profit through their property buying and selling activities are traders and already tend to satisfy their taxation liabilities. These people will still buy and sell a property if the numbers are satisfactory. Will the bright-line test stop property prices increasing? Highly unlikely I think. I've already written a blog on capital gains tax and housing. Capital gains tax has had no effect on capping property price increases in Australia for example. Why should Auckland be any different?

Reserve Bank – New Official Cash Rate Limits and Mortgage Interest Rates
Meanwhile, back at the ranch, Mr Wheeler had another dilemma to contend with:  hold the Official Cash Rate (OCR) and let us suffer economically, or cut the OCR and possibly add fuel to the Auckland property market. In the end he chose to stimulate our economy on the basis of the New Zealand-wide economic outlook and low inflation. He reduced the OCR to 3%.  

Because the OCR directly affects wholesale borrowing by banks, a cut in the rate tends to flow through to the interest rates borrowers of loans are charged. Predictably, following the decrease in the OCR, banks reduced interest rates, and equally foreseeable, borrowing to buy houses turned from busy to manic. 

At the time of cutting the OCR, the Reserve Bank Governor indicated further easing seemed likely. Bank economists have commented the Reserve Bank is likely to make such cuts given the slump in dairy prices and the weak wage growth currently experienced. If this is the case, how low could the OCR go? Forecasts have said rate cuts could be made throughout this year and into next year, with the OCR falling as low as 2%.  

Will the effects of a lower OCR be passed on to borrowers by New Zealand banks? Possibly, but not necessarily so. Banks have to source their funding from somewhere, often from depositors who demand a certain interest rate or they simply won't reinvest their funds. If banks are to capture term deposit funds, they may have no choice but to offer good interest rates. Ultimately, this could cost a bank. In an effort to mitigate against this effect, a bank may not be keen to pass on savings as a consequence of a lower OCR. Additionally, potential new Reserve Bank policies may also curtail the passing of OCR cuts to borrowers.

Reserve Bank – Potential New Capital Requirements for Banks
It's been whispered the Reserve Bank may introduce further policies to aid financial stability of our monetary system. The Governor may require banks to hold additional capital for the loans they make available to investors than what they currently do. Clearly this will have a cost to banks, which may be passed on to investors. Couple this with the new LVR policies and investors could feel pinched. Alternatively, banks may decide or be permitted to absorb such costs themselves. If this is the case, I imagine they will still seek to keep their profits at a certain level. Ultimately this may mean OCR cuts won't translate into large loan interest rate cuts to be enjoyed by borrowers.  

Solving the Dilemma 
Given the above, what should you do if you are going to borrow new funding or refinance existing loans?  

At first blush you might think floating is a sensible option because you could then fix your loans if interest rates decrease without incurring penalty bank fees. But remember, floating rates tend to be more expensive than fixed rates because banks subsidise fixed rates at the expense of higher floating rates.

So possibly you may choose to fix. If I was going to do this, I'd fix for a short period of time given that I'd want to keep my options open somewhat to take advantage of lower interest rates in the future if they were on offer. I'd also ensure I borrow different amounts of money, for varying fixed periods of time, at differing interest rates, as interest rate tranching would assist.  

Ultimately however, how you structure your new loans and/or refinanced loans will depend on your personal financial circumstances, including your risk profile.  You'll need to make your own decisions but using special fixed versus floating calculators can undoubtedly assist with your decision making  So can we, for that matter.  Should you want to discuss your property, structural, tax, accounting and/or financial affairs, please contact us on [email protected], via our online form, or by phoning (09) 522 7955.