Where are interest rates heading?

What’s going on?

I thought the Reserve Bank set interest rates? And why are interest rates rising?

I thought we were supposed to be heading towards a recession?

All good questions.

Rightly or wrongly, the big four banks have all started to raise interest rates independently of the Reserve Bank.

Also read: Housing busts, booms and Westpac hysteria

It’s all a response to the Financial System Inquiry – a review designed by the former boss of the CBA, David Murray, to find out how we can make our financial system safer and fairer.

The review basically said that the banks need to bolster the amount of cash they hold to ‘protect’ themselves from another financial crisis.

Also read: Bouris: ‘Why the banks are really hiking rates’

The banks said, ‘sure, no problem, we can raise the cash, but it’s going to cost us, so we’re going to jack up our interest rates to cover some of that cost’.

It’s thrown a spanner into the works about a whole host of economic issues but, importantly, does it mean interest rates are now going to keep rising, and if they do, should I fix my home loan?

First, let’s look at whether you should even be looking at taking out a home loan in the first place.

Where is the property market going?

Everyone has their own view on the housing market. If you’re an investor you believe prices will continue to rise.

If you’re a first home buyer, you’re hoping for a market correction.

Deutsche Bank’s hardly sanguine. It recently released a note saying, “On the equity market, investors seemed to be pricing in a fall, meaning that housing sector-exposed stocks were now trading at a 5 to 10 per cent price-earnings discount to the market.”

Macquarie Group has also recently shown its hand.

One of its analysts released some research a week or so back saying he expected a 7.5 per cent fall in prices beginning in March.

Also read: CBA raises mortgage rates

The reality of course is that there’s no such thing as a single market for Australia’s housing stock. Each state has a different make-up, and frankly, so does each city and suburb.

When you break down the numbers it’s clear there could be a mixture of winners and losers for those who decide to punt on the market.

Louis Christopher from SQM Research has been crunching the numbers, and if his figures are anything to go by, it's Melbourne that's going to come out on top.

Property prices in Melbourne are expected to rise as much as 13 per cent next year.

Hobart's set for a nice little boost, with prices up close to 7 per cent. Perth's property market's expected to hit the skids, with prices down between 4 and 7 per cent. Darwin will also be licking its wounds as prices fall between 2 and 6 per cent.

Sydney's expected to slow down next year too but there’s no talk of a property market crash with prices predicted to rise between 4 and 9 per cent.

Also read: NAB hikes interest rate

Louis Christopher told me last week that he thinks there will be a correction in the property market, but not anytime soon.

He says a market like Sydney has too many strong economic tailwinds. Anyone can see that too by spending even a small amount of time in the city.

Official data also shows that borrowers are still taking advantage of low interest rates. In the Reserve Bank’s latest Financial Stability Review, it stated that, “An increased willingness by some households to take on more debt, coupled with slow wage growth, has resulted in a further pick-up in the gross debt-to-income ratio, which has now reached new highs.”

Or put in plain English, consumers are still as keen as mustard to take out a property loan – despite being a little over-exposed or over-leveraged.

Borrowers are only ‘exposed’ though if interest rates start to rise. We touched on this at the start of the column but let’s revisit that briefly.

Then we can get onto the fun stuff – working out if you’d be better off fixing your rate, or going with a variable rate.

Where are interest rates going?

Last week the ANZ Bank rounded out the big four banks in raising interest rates.

So on say 5.68 per cent (which is Westpac’s rate), a borrower on an average $300,000, 30-year loan, will very roughly pay an extra $500 a year.

The average standard variable rate is now around 5.6 per cent. The CBA’s Standard Variable Rate is a case in point – set to increase by 15 basis points to 5.60% for owner occupied home loans.

Fixed rates for the Commonwealth Bank though haven’t changed, with the current Owner Occupier Wealth Package 2-year fixed rate remaining at 4.29% per annum.

The average three-year fixed rate though is now at 4.54 per cent

So it’s clearly cheaper to take out a fixed rate loan. Or is it?

Also read: Westpac to raise variable mortgage rates

You see one of the arguments those in favour of choosing variable rate loans make is that interest rates could fall further still.

That could come about on the back of an international economic shock, or indeed if Australia falls into recession.

The Reserve Bank might also want to bring the commercial banks back into line by dropping the official cash rate. Who knows?

AMP Capital’s Shane Oliver is certainly in the camp of forecasting the Reserve Bank could lower interest rates as early as Melbourne Cup Day.

So let’s take stock.

You’ve weighed it all up… you’re going to buy a house because prices are still heading up, and you think interest rates could drop further – variable it is.

A wise decision?

Quite possibly.

The latest figures show the proportion of new borrowers choosing to fix their mortgage is at its lowest level in four years.

I mean, c’mmon, the obvious answer is to fix your home loan rate at such low interest rates, but the truth is that wages growth has slowed to a crawl, and the property market is hard to get into, so borrowers are looking for every extra dollar.

There’s simply more chance of being better off under a variable loan. Indeed taking that financial risk at present seems to trump the security of knowing you’re repayments are covered under a fixed-rate system.

Is it really that difficult a choice anyway? Comparison website, Canstar, says three-year fixed rates start at just 3.89 per cent.

That’s obviously quite competitive. It’s also roughly the same as the lowest variable rate deals, but it’s got the benefit of being locked in until late 2018. Be careful though.

There’s also the important consideration of having flexible repayment options. Please be aware that sometimes under a fixed rate loan you can’t fast-forward or turbo-charge your repayments.

To fix or not to fix

For my mind, it seems sensible to go with a variable rate.

That’s based on the view that the recent rate rises by the commercial banks seem to be a one-off event, and in any case the Reserve Bank may have to keep interest rates in check by moving the official cash rate to counter-act what the commercial banks do.

That’s easier said than done of course, but anyone can see the Australian economy isn’t prepped for broadly higher interest rates. With the flexibility to pay your loan off faster, who wouldn’t want a competitive variable rate loan?

Of course, it goes without saying that if you’ve found your dream home, and you’d like to stay there ‘forever’, and you have a steady, reliable income, and you want to be free from the financial stress of the rates cycle, go ahead and lock in a competitive fixed rate for as long as you can.

The point to make is obvious. There’s no one answer.

Different options work for different borrowers. One thing you can bank on though is that the lenders want your money, so be up-front, demand a good deal, and be prepared to walk away.

David Taylor is a journalist with the ABC. Before taking up a position with the ABC, David was a financial markets analyst and economics commentator.