There are few concepts more important in investing than ‘asymmetric risk’ – the idea that you should buy assets when the likely upside is greater than the likely downside.
The principle is just as applicable to managing debt, particularly if you’re at the more heavily indebted end of the mortgage market.
To see why, a good starting point is economic growth and its impact on job security.
This week’s GDP numbers came in looking pretty healthy at first glance, so a first home-buying couple might think: “Our jobs are secure enough, interest rates are very low, so although our debt it huge it should be manageable.”
But the headline GDP growth of 3.1 per cent in trend terms, doesn’t tell the full story.
A better guide to the prosperity of households is ‘real net national disposable income’, which rose only 2.1 per cent in trend terms.
That’s the best yearly figure we’ve had since late 2011, but is also only the second quarter since that time in which that figure has grown more quickly than the population.
Moreover, while the overall population is growing at 1.4 per cent, Australia’s high intake of working-age migrants means the workforce is growing at 2.6 per cent – all at a time when the number of hours worked in the economy is flat-lining.
From this moment in time, then, many highly mortgaged households risk some form of underemployment in the next few years.
Asymmetric mortgage risk
Australians have become very comfortable with the idea that rates will stay very low for a very long time, primarily because politicians and the Reserve Bank itself keep telling us so.
That may, indeed, come to pass. However, the ‘asymmetric’ part of interest rates equation is this: super low rates cannot go much lower, but there are risk factors that could cause them to move much higher in the medium term.
Key among those risks is the Federal Reserve. It imposed its first rate rise last December. A second rise, still predicted to be before the end of 2016, will push up offshore borrowing costs for Australian banks.
When combined with growing competition for domestic deposits, that will put upward pressure on mortgage rates – even if the RBA keeps cutting its record-low cash rate in an effort to pull them lower.
To fix, or not to fix? That’s the big question
That’s why at this point in time, heavily indebted borrowers should look again at fixing their interest rate.
Fixed rates exist to help manage risk by smoothing rate fluctuations that might flow from, say, a global stock market rout (which would lower rates) or new waves of stimulus spending, here or abroad, which could increase rates.
To use a real example, Bendigo Bank is currently offering a variable loan at a comparison rate of 4.46 per cent, or the option to fix the loan at a comparison rate of 4.45 per cent for three years or 4.65 per cent for five years.
There is the risk, if you fix your loan, that variable rate mortgagees will be paying, say, 3.8 per cent within two years. On a $450,000 loan over 25 years, that would mean paying $214 over the odds each month.
On the other hand, if inflationary forces begin to act – such as a surge in Chinese stimulus spending, additional Federal Reserve rate rises or higher oil prices – the RBA might have to hike rates.
Between September 2009 and November 2010, for example, it increased the cash rate from 3.00 per cent to 4.75 per cent to offset just a surge in demand for Australian resources.
Borrowers can’t be expect to be across all of those probabilities.
However, the simpler question to ask when looking at fixed rates is: “Can I afford an unforseen rate hike, and what’s the cost of paying to avoid it if it never comes?”
If the 2009-2010 tightening cycle happened again – admittedly not likely – a variable loan mortgagee could be looking for an additional $466 a month.
Most importantly, if you understand asymmetric risk properly no decision is a mistake – even if you lose money, it was made with the best information at the time.
Predicting the future may be a mug’s game, but with job uncertainty, record household debt, and record low rates, now’s a pretty good time for mortgage holders consider buying some peace of mind by fixing all or part of their debt.