Should you fix the interest rate on your bond?

SHOULD YOU FIX THE INTEREST RATE ON YOUR BOND?

There are many developments in the world of late, particularly arising from the conflict in Ukraine. The corresponding impact on oil, on food prices, CPI inflation will ultimately impact on our interest rates here at home.

Several of our clients are having discussions with us about the interest rate increase.

The recurring question being asked by consumers is whether they should fix their bond interest rate on their mortgage bond?

Most bonds are signed with variable interest rates, i.e., based on the prime lending rate (adjusted to each consumer based on their creditworthiness).

Let's first discuss the differences between the two. Briefly, they are:

Variable:

If the prime lending rate (the rate at which the bank lends money to consumers) goes up, then so does the required bond instalment. That is essentially what a variable interest rate means.

Fixed:

If you fix the interest rate, then the interest rate will not vary with prime is fixed for the set agreed period.

So should you fix your interest rate on your bond?

In 2006 - 2008 interest rates shot up from 10.5% to 15.5% due to the global financial crises. In that instance there was a bubble, and it burst.  Crude oil also went up to US$150 and the South African Reserve Bank reacted by increasing the interest rates.

Today, however, we are slightly better positioned. Consumer debt as a percentage of income is lower (68% vs 79%), so the ability to absorb interest rate increases is better.

Brent Crude Oil has increased by 74.64% in the last 90 days, from about US$80 to a peak this week of US$129. Yesterday it was US$112. This increase in Brent crude oil is as a direct result of the Ukraine conflict, sanctions, supply side shortages. The likely effect in South Africa is an increase in the price of fuel.

An increasing petrol price means that there is less disposable income, increases in food prices, and ultimately an increase in inflation.

Some articles suggest that petrol could go up by R2.50 per litre in April. This increases inflation, which will have the effect of increasing the prime lending rate as a result (to curb inflation).

For example, petrol was R16.58/litre in April 2021, it is currently R21.00. It could go to R23.00/litre (that a R7.00/litre increase or 40% in 12 months).

The interest rate was increased on 24 March 2022 by 0.25%.

The MPC met and increased the interest rate. It is important to note that two out of five voted for 0.5%, but as they were not the majority, we got a 0.25% increase.

What are the justifications for fixing your interest rate?

When a bank fixes the interest rate, they typically do so at a premium rate. 

For example, if prime is 7.5%, the bank will typically fix the rate at 9.5% or more (usually for a period of 2 years), and then review it systematically.

The banks have teams of economists (lots of smart people crunching numbers) and lots of data to apply to this concept.

The average consumer doesn't generally have the ability to outsmart the "bank" and fix it at a rate that is advantageous to the consumer.

So, instead of fixing your interest rate, Seeff suggests that you rather pay more into your bond (as if the interest rate had increased). 

So, if the increasing interest rates are a concern for you, rather keep the rate at prime (7.5%), but pay the instalment as if it was 9.5%.

By doing so you will have two benefits: 1) You pay off capital sooner (by paying more than required) and 2) You get the benefit of the lower variable rate on your bond but at the same time preparing yourself from a cash flow position should the interest rate increase to a higher amount (instead of fixing it 2% premium points above prime).

So, unless you are an expert in economics/oil/interest etc., or have the necessary skills and the conviction that interest rates will increase by more than the banks premium at which they fix interest rates, we do not suggest fixing your interest rate.

To summarise, whilst we expect interest rates to increase, we advocate that instead of fixing the interest rate on your bond, rather increase your bond instalments to mimic a higher fixed rate.