As the Trustee Services Partner at Gilligan Rowe & Associates, I’m often asked by Trustees what we think is going to happen in the economy, the property market and with interest rates. We answer questions like this all the time as helping people make and protect their money is our business. The one million dollar question is on the table again - does a Trust fix its interest rates on its existing loans right now or not?
The last thing Trustees want to do is fix a Trust loan at a rate of say 7.25% pa and then rates move downwards the following month. Likewise, a Trustee will not be happy when they choose not to lock in their loans and find rates move upwards and against them and the Trust.
A couple of months back the answer to this one million dollar question would have been fairly clear. Now however, it really is a game of snakes and lizards and everyone is wondering which way they should roll the dice. Below are some tips that might just help you decide what to do with Trust loans.
THE RESERVE BANK AND THE OCR
In simplistic terms, the Reserve Bank’s main job is to establish and implement monetary policy. It does this by setting the Official Cash Rate (“OCR”) with an aim of controlling economic activity and inflation. How does this affect Trustees and Trust loans?
Well, again in very loose terms, banks borrow money which they then lend on to us. Banks borrow money from several sources such as from overseas lenders, term deposit holders and of course, the Reserve Bank.
When a bank borrows funds from the Reserve Bank, it usually does so at a rate around the OCR. When a bank then lends funds on to us, it does so by putting a bit of a margin on those funds. So if a bank borrows funds from the Reserve Bank at say 5% and if it adds a mark up of say 2%, we can expect that bank to lend those funds to us at 7% or thereabouts.
Accordingly, when the OCR moves, it affects the wholesale rates Banks borrow funds at which in turn, affects the interest rates the Banks are prepared to lend money to us at.
When setting the OCR, the Reserve Bank looks about 2 years out. In other words, the Reserve Bank doesn’t just deal with what is going on right now in our economy when it sets the OCR. Rather, it looks about 24 months ahead and sets the OCR on what it expects is going to happen in the future.
In the last OCR review, which happened on 29 July 2010, the Reserve Bank set the OCR to 3%. The Reserve Bank said the economy might not grow as quickly as previously thought and inflation might not reach the heights it was previously expected to reach in 2012. What does this mean for interest rates?
If all was going according to the Reserve Banks prior expectations, the OCR would have risen to around the 6% mark by the end of 2012. That meant we could have expected interest rates to be around the 9% mark by the end of 2012. But now that the Reserve Bank has brought back its expectations, it thinks the OCR will only reach 5% by the end of 2012. This of course means interest rates could come back a bit, to around the 8% mark.
So given the above information, does a Trustee fix or continue to float the Trust’s existing loans?
If a Trust’s existing loans are on floating rates right now, you might as a Trustee, choose to continue along this path if you think New Zealand’s economy will be long and slow in growing. Of course if you hold this view, you’re be expecting interest rates to stay low and the OCR not to rise as quickly or as high as was previously envisaged. You will recall the Reserve Bank has recently indicated this.
As a Trustee you might also continue to float if you think the global situation (especially in Europe) will deteriorate. Why would you do this? Well a deteriorating global situation could lead to a decrease in the rates our Banks pay to pick money up off shore. If banks have to pay less to get the moolah that they on-lend to us, then perhaps they won’t charge us so much for the pleasure of borrowing it off of them e.g. fixed rates will come down.
If a Trust is in funds, perhaps it receives rental income for example, you may as a Trustee be intending to pay off some of the money the Trust owes the Bank on its existing loans. If this is the case as a Trustee you would probably also choose to float because if you fix the Trust’s loans, penalties may be incurred for making early repayments.
If you are thinking you might fix the Trust’s interest rates on its existing loans, you are probably of the mind that the International Monetary Fund growth forecasts will come true. Likewise, I expect you will believe the New Zealand economy is going to experience fairly rapid growth and inflation in the near future. You might be basing your Trustee opinion on the fact that the vehicle sales, dairy, forestry, education, exports and manufacturing sectors in our economy have grown and will continue to grow at a relatively quick pace. Of course if you hold these beliefs, you will be expecting fixed interest rates to increase. As a Trustee wanting to do the best for the Trust’s beneficiaries, you will be hoping to get in early so the Trust doesn’t have to suffer the rate increase later on. Hence, you are likely to fix the Trust’s interest rates now.
The Trust might also be in a financial position of being able to pay the additional monthly increase in payments it is going to experience if the rate is fixed now. I say this because if the loan is currently on a floating rate, the Trust is probably paying around the 6% pa mark. But if as a Trustee you choose to lock in the interest rates right now, you are most likely going to do so around the 7.0% to 7.3% pa mark. Consequently, the loan repayments will increase in size.
Of course the extra the Trust pays in loan repayments on a fixed rate might well be worth the peace of mind that is gained. Which is another reason why a Trustee might choose to fix their interest rates.
LOOK LEFT AND LOOK RIGHT BEFORE YOU JUMP
This heading says it all. Whatever you decide to do, get some information before you implement your decision. Do the numbers. Work out the figures. Check to see which alternative will be to the Trust’s financial advantage. Get help from someone independent. By the way, your bank is not independent.
If you need help doing this financial check, then talk to us. Over the years we have helped thousands of clients with their Trust affairs. Of course a large part of our role is working out what is advantageous to clients from a financial perspective. This includes Trust clients and businesses and individuals. So give us a call on (09) 522 7955 for a free chat. We’re here to help you.
Until next time …ciao.