Buying a house privately in New Zealand always seems to be in the news, thanks mainly to the housing market being so buoyant for so long. Home loan interest rates are at low levels, making them an enticing prospect for homeowners and those looking to invest.
Interest rates are made of many parts.
The first thing to understand is that a home loan interest rate is made up of many parts and that a bank doesn’t simply pocket all the interest it receives from people with home loans. It all has to do with the way a bank makes money. Since a bank is a business, it needs to return a profit to its shareholders, just like any other business would. For a bank to make money, it needs to be able to sell its product (money) for more than it costs to produce (borrow). Here’s how that works in practice.
Where does a bank get its money from?
Banks get their money from a range of sources. One of the largest sources is from deposits in bank accounts. These deposits include savings and cheque accounts, term deposits, PIEs, loans, credit cards, bonds and so on. In effect, anyone with money in a bank account or term deposit is “lending” the bank their money. The bank pays them interest in return and promptly puts that money to work by lending it out again for a slightly higher rate of interest. That’s why interest rates on savings are always lower than home loan rates.
In addition to bank deposits as a source of funding, banks also borrow money from the Reserve Bank of New Zealand and overseas sources. When the cost of borrowing this money goes up or down, that cost (or saving) generally gets passed down the line to customers, which is when we see our home loan rates rise and fall.
What about the OCR?
You’ve probably heard about the OCR (Official Cash Rate) and how it can affect home loan interest rates. The OCR is set by the Reserve Bank to influence banks’ interest rates. If a bank needs money that it can’t get immediately from deposits and other sources, it can borrow from the Reserve Bank at a slightly higher rate than the published OCR. If the OCR goes down, so might your home loan rates… but not always. That’s because banks get their money from many different sources, so the OCR is only one factor that influences overall home loan interest rates.
The role of uncertainty in interest rates.
Of course there’s more to it than that, but on the whole, that’s how the system works. There’s a constant flow of money back and forth between all these different entities, which can create uncertainty. It’s for this reason that longer fixed-term home loans generally have higher interest rates than short-term ones as they provide relatively more certainty. Even though your home loan interest rate might be fixed, at say 5% for the next three years, the bank’s cost of maintaining that home loan might rise during that same period, affecting the banks’ margin.
How can you make the most of all this?
While there’s not much you can do about the interest rates, there are plenty of ways to manage your home loan to maximise efficiency and pay less interest. Locking in a fixed home loan is a good idea when interest rates are low and you think they will increase. On the other hand, if you think interest rates are going down, a variable (floating) home loan rate will give you more flexibility and does not lock you in with a set interest rate for a fixed period of time.