Interest rates and gearing (part two)

- Caglan Bagci | NZIJ MORTGAGES


As I write these words, the prime mortgage market (where borrowers have a choice of where they source their money) offers a range of interest rates from 5.95% variable through to just over 8% for a 5 year fixed rate loan. The lowest interest rates are around 5.5% for a 1 year fixed rate period. 

The one thing that is certain about interest rates is that the future is uncertain.  We can not accurately predict future interest rates.  For this reason we can never guarantee that any particular home loan strategy will ever save someone money. 

For example if you were to take a one year fixed rate loan today on the basis that it offered the lowest interest rate and discovered on maturity that interest rates were 3% higher, then you would wish you had taken a longer term fixed rate. The longer term fixed rates are more expensive now but will possibly save you money in the long run.

If the monthly budget is tight with no easing expected in the foreseeable future, a longer term fixed rate is appropriate. The borrower will have difficulty in coping with possible increases in interest rate. If, however, there are good monthly surpluses a shorter term fixed rate is the preferred option. It will save money now and increases in interest rate can be dealt with should they occur. Generally investors should work with a longer time horizon than owner-occupiers.

In last month’s article I went over the concept of gearing and suggested that you look for positively geared investment properties. I did the same, and found that with current interest rates, it is possible to borrow 100% of the value of some properties and still have them positively-geared (where income is greater than outgoings).

As a general rule, the better the location of a property the lower the yield and the more likely it will suit a negatively-geared investment approach.  The higher yields tend to be found in locations where property is cheaper to buy or in specific market segments such as student accommodation.

To understand why this is, consider a high rise apartment building. A penthouse with the most spectacular views is significantly more expensive to buy than other apartments in the same building. And generally the lower the apartment is in the building and the less interesting the outlook, the lower the buy price of the apartment. The rental income that the various apartments are capable of generating will vary but not as significantly as the buy price of the various apartments.

I have observed property investors succeed with both a positively-geared approach and a negatively-geared approach. The more professional/full time investors prefer the positively-geared approach as an independent income is not required to service debt and other outgoings.  The part-time investor who is on high taxable income has tended to prefer a negatively-geared approach as they are looking at reducing their tax liability and want the benefit of long-term capital gain. Either way can work.  It all depends on what is best for the personal situation of the individual.

As usual I am happy to respond to any questions on this article or anything in previous issues.  Send your questions to mortgages@nzij.co.nz