How are home loan interest rates determined?

Banks use both domestic and international wholesale rates to determine the amount of interest that you’ll pay on your home loan.

Many people closely watch the Official Cash Rate (OCR) here in New zealand in the hope that they’ll be able to pick when the time is right to grab a good fixed home loan rate.

The bad news is that interest rates are not only affected by the OCR.  At the present time, the USA is stopping their quantitative easing (money printing) process and this has caused wholesale interest rates to rise.

The average person is too busy going about their day-to-day lives to be interested (no pun intended!) or concerned about how the global economy affects our home loan rates here in New Zealand.  In reality, New Zealand doesn’t exist in a vacuum, we are very much affected by what happens elsewhere in the world.

With a little understanding of how interest rates are determined, it makes sense that the longer you fix your rate for, the more you pay for that certainty.  For the bank to offer you an interest rate term of 3 or more years, they need to make sure that they have factored in enough of a margin for international wholesale rate variations during the term.

Historically, shorter (1 year or so) terms have outperformed the longer term interest rates.  The longer term rates are more affected by what is happening overseas and the shorter term rates are more influenced by the OCR based on the domestic economy.

Longer term (3 year or longer) fixed rates are offered to give some certainty to those purchasers who really can’t manage an increase in their home loan payments in the first few years of home ownership.

By all means, split your loan to take advantage of a range of interest rates.

If you want to benefit from New Zealand’s current low OCR then you need to either choose a floating rate or take a shorter fixed term.  You are taking a risk though because rates will rise and nobody knows when, or how quickly, they will rise..

At present banks are trying to encourage people to take a longer term fixed rate.  The banks are making very little profit from the highly competitive short term interest rate market.

If you can afford your home loan repayments (use one of the banks’ calculators) even if interest rates were to rise a couple of percent, then it might be worth taking a gamble on a shorter term for a bit longer.

Shorter terms also give you more flexibility in paying off extra each time your fixed rate rolls over.

If you fix for 3 or more years, then you can’t pay extra (without penalty or at least administration fees) during that 3 years.

Don’t worry too much about the rate, but concern yourself with getting rid of your home loan as quickly as possible by paying off more than the minimum.


[Oh, and don’t forget, I’m not a financial advisor, choose your interest rate and term based on your own risk profile! :-)]

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