Interest rates make it lucky for some

By MARK FRYER

Here in the news business, interest rate rises tend to get relegated to the "bad news" category.

Every time Don Brash lifts rates - as he did again this week - there are the usual complaints from business, and calculations of how much the increase will add to mortgage payments.

But rate rises cut both ways; for every home-owner worrying about the mortgage, someone else is looking forward to earning a little more on their term deposit.

The two-edged nature of higher interest rates is worth keeping in mind, as rates continue on the upward path that began late last year.

The question now is not whether higher rates are good or bad news, but where they are going from here and (if you're one of the losers) how to minimise the damage, or (if you're a winner) how to make the most of it.

The answer to the first part of the question isn't difficult; unless there's some sort of economic cataclysm, interest rates are going up, at least in the near future.

On the local front, the Reserve Bank is worried about what it regards as an over-exuberant economy, which threatens to push inflation above 3 per cent, the maximum the bank is meant to tolerate.

The bank has reacted by raising its official cash rate - which sets the trend for short-term interest rates, including floating rate mortgages - by 0.5 percentage points since the beginning of the year, from 4.75 per cent to 5.25 per cent.

Things are still on the way up. Many economists expect another increase of 0.5 percentage points next month. A poll of economists by the Reuters news agency this week found that on average they expect the official cash rate to reach 6.29 per cent by December.

Some expect it to peak about there, while others forecast more increases early next year, pushing the rate to 7 per cent or so.

In the real world, those forecasts suggest that the major banks will be charging 8 or 9 per cent for floating mortgages by the end of this year or early next year.

At the beginning of this week the going rate from the big banks was 7.2 per cent, although WestpacTrust has already raised that to 7.5 per cent following the Reserve Bank's latest increase.

For investors, short-term rates, for things such as term deposits of up to 90 days, are likely to rise with the official cash rate.

Longer-term rates, for borrowers and investors, are more likely to be influenced by what happens overseas.

Most have already risen in anticipation of interest rate rises in the rest of the world. What happens next depends largely on the strength of overseas economies, particularly that of the United States.

THE WINNERS

While borrowers worry about rising rates, the winners at this stage of the economic cycle are those who have money to put into fixed interest investments.

Not that it's a big win. If you stick with bank term deposits, the rates on offer now - up to 7 per cent or so for five years - will provide a modest real gain, after deducting tax and inflation, but won't make anyone rich in a hurry.

And economists aren't predicting a return to the high interest rates of old.

"You're not rushing back towards 11 per cent bank deposits," says WestpacTrust chief economist Adrian Orr.

To do better than the banks offer, you'll need to venture into areas such as finance company debentures and corporate bonds, always remembering that nothing is free and that higher returns go hand-in-hand with higher risk.

For many investors, the big question now is whether to lock their money away in a term deposit for the next few years, or wait for rates to go even higher.

Those longer-term rates still have a little room to rise, but not much, says Orr.

"We're not too far away from saying this may be as good as it gets, in terms of rising returns on deposit rates," he says, and the rise from now may be only 0.5 per cent or so.

His counterpart at the BNZ, Tony Alexander, expects the five-year term deposit rate to rise by another 0.5 to 0.75 percentage points before it peaks.

"If you like term deposits, you probably want to go short at the moment ... and then maybe pick up a nice longer-term interest rate, who knows, maybe in six to nine months' time," he says.

ASB Bank chief economist Anthony Byett says: "The strategy would be to stay short-term as an investor.

"Okay, you give up a little bit of return right now ... and then longer-term, in six months or a year's time, you're in a better position to hopefully take advantage of what will be relatively high long-term yields."

If you're uncomfortable about making those sorts of decisions, one simple tactic is to split your money into several fixed-interest investments of various terms, so they won't mature at the same time.

You might miss some of the time but you won't miss all of the time.

One group of investors who won't be so happy about rising rates are those with money in things such as government stock or corporate bonds, or managed funds which invest in those areas.

That's because rising interest rates make existing investments of that type worth less.

If you own such investments directly, the loss of value may not be obvious, unless you have to sell before the maturity date.

If you invest in that area through a managed fund, which will be regularly re-priced to reflect the changing value of its underlying investments, you can expect to see your returns go on suffering as interest rates rise.

THE LOSERS

You're in this category if you're paying interest.

People with mortgages are the most obvious example, given that we collectively owe about $67 billion on our homes, but rising rates are hitting other borrowers as well.

If you're lucky enough to have fixed back when rates were lower, you can smile smugly.

If you're on a floating loan, taking out a new mortgage or refinancing an existing one, the choice now is between fixing or sticking with the floating rate and hoping things don't rise too much.

"Fix, but not for too long" suggests WestpacTrust chief economist Adrian Orr. Perhaps for one or two years. "You wouldn't want to fix for much longer at these rates because, say by early next year, odds-on those fixed rates might be starting to come off a bit."

It's much the same story from BNZ chief economist Tony Alexander.

Cheap fixed rates disappeared late last year, he says, and "if people want fixed now, really all you can justify is going maybe one or two years.

"Longer than that and it's really getting too expensive ... compared with where we see the floating rate going."

"A three-year rate at say 8.3 per cent would probably suit some risk-averse home buyers, but I think most home buyers would really be better off going for the one- and preferably two-year term."

The economists' argument is that a lot of the interest rate rises expected in the future are already built into the fixed interest rates available now. By later this year, they argue, fixed rates could be heading down.

In fact some lenders cut fixed rates this week, at the same time as they were increasing floating rate loans.

But deciding whether to fix or float isn't just about predicting interest rates, says Orr. It's also a question of how much risk you're prepared to take.

"How much certainty do I need to get?" he asks. "With a five-year [loan] at 8.6 [per cent] that's probably a bit high, so you'd want to lock in but not forever at these levels."

ASB Bank chief economist Anthony Byett says that, based on his forecasts of where rates are going, deciding whether to fix or float is "a 50/50 call".

"What that doesn't cover is the risk, and given that we're in that window where rates can go anywhere upwards, it probably does pay for most people to fix, particularly for one or two years."

"If you are a first-time buyer and you have a large loan relative to the value of your house and relative to your income, you need to fix it - you can't take the risk," says Byett.

"If you're an older person, you've only got $20,000 or $30,000 left on your mortgage and your income is way in excess of the cost of servicing that, take the risk if you feel that way inclined."

And, wherever rates go, it pays to shop around. Even a 0.5 percentage point difference in the mortgage rate can make a big difference to its total cost.

* To contact Personal Finance Editor Mark Fryer, write to: Weekend Business, PO Box 32, Auckland. Phone (09) 373-6400 ext 8833. Fax: (09) 373-6423. email: mark_fryer@nzherald.co.nz