Owning a home

How mortgage rates are calculated

3 min read

Home loans are in the news a lot these days thanks mainly to the New Zealand housing market being so buoyant for so long. Interest rates on those loans are at low levels making them an enticing prospect for homeowners and potential buyers.

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. The bank’s profit on a home loan is smaller than you might think.

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 owners shareholders, just like any other business would. Of course, a bank being a bank, it’s product is money. 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 overseas sources. When the cost of borrowing this money goes up or down, that cost (or saving) generally gets passed down the line to us, 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 rates. The OCR is simply the rate of interest the Reserve Bank of New Zealand charges banks who borrow from it. If a bank needs money that it can’t source 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 plays only a small role in affecting overall home loan 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 have higher interest rates than short term ones. Even though your home loan rate might be fixed at, say 6% for the next five years, the bank’s cost of maintaining that home loan might rise during that same period, affecting the margin the bank is able to obtain.

How can you make the most of all this?

While there’s not much we can do about the interest rates, there are plenty of ways to manage your home loan to maximise efficiency and pay less interest. When rates go down, it’s a good time make extra repayments on your home loan which can, over time, significantly reduce your interest costs. Alternatively, if rates go up and you find you're struggling, you still have options.

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