Variable rates look like the best option

Competition in the Irish mortgage market has never been keener, which is good news for first-time buyers or for those on fixed rates coming to the end of the term. Discount mortgage rates are available from some lenders, but the key issue for many borrowers is whether to opt for a fixed rate, with its attendant certainty in terms of monthly payments, or to go the variable route, particularly as rates are likely to rise further in the near term.

Fixed rates have certainly grown in popularity in Ireland: some three-quarters of new mortgages in the third quarter of 1999 were fixed, against just 44 per cent in 1995, although this had fallen back to 66 per cent in the fourth quarter of last year. In fact, most of these fixed rates are taken for relatively short terms of up to three years, although fixed rates up to 10 years or even 20 years are now available. However, longer fixed rates are not attractive at the moment, and indeed it is hard to make the case for fixing beyond one year, given the current interest rates on offer.

Variable or floating mortgage rates tend to be determined by the cost banks have to pay to borrow cash for three months. This, in turn, is closely tied to the ECB's repo rate, which has already risen by 1.25 percentage points since November. The repo rate is currently 3.75 per cent and although some mortgage rates are available near this rate, the standard mortgage is around 1.1 percentage point higher at 4.8 to 4.9 per cent. So, if the repo rate rises to 4.5 per cent by year end, as many expect, the standard mortgage rate in Ireland may end the year at 5.6 per cent.

Borrowers opting for variable rates can, therefore, expect to pay more as the year progresses, although rates are unlikely to rise much beyond 5.6 per cent. However, there is always a risk that such forecasts prove wrong, which is why many people prefer the fixed route. Unfortunately, the expectation that the ECB will raise rates further is already priced into longer term money market interest rates, which in turn determine the cost of fixed mortgages.

For example, Irish lending institutions would have to pay around 5.4 per cent to borrow three-year cash, and 5.6 per cent to borrow five-year cash. This explains why three-year fixed mortgage costs are generally 5.85 per cent or higher, and why five-year fixed rates are around 6.35 per cent or above.

In fact, the money market is pricing in a much higher repo rate than 4.5 per cent, which is why fixed rates are not attractive at the moment. Take a borrower with a £72,000 mortgage (the average new mortgage in 1999). A fixed three year rate at 5.9 per cent is around one percentage point above the variable rate, with a cost of £575 per month, against a current variable cost of say £474 per month.

Of course, the variable can and probably will rise, but even if it reached 5.9 per cent in 18 months, it would have to exceed the fixed by another 1 percentage point (i.e. reach 6.9 per cent) over the final 18 months to equal the cost of the three-year fixed rate.

On that basis, there is little justification for borrowing fixed for more than two years unless one is very pessimistic on European interest rates or one can obtain a special deal. The exception is one-year fixed, with some available at the current variable rate. The chances of variable rates falling across the board within a year are low and there is the upside protection at zero cost. Apart from that, variable rates look the best option.

Dr Dan McLaughlin is chief economist of the ABN AMRO Group