Busting the home loan interest rate myths

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There is a lot of confusion about interest rates and why they move as they do:
  • Why don’t banks pass on the full rate cut when the Reserve Bank of New Zealand (RBNZ) moves the cash rate down by 0.25%?
  • Why do the banks move their rates down, even when the RBNZ doesn’t cut their cash rate?
  • Why do the major banks, and the mortgage originators, such as mortgage brokers’ interest rate movements, fall out of sync with the RBNZ?

Magnifying Glass“The Reserve Bank cash rate sets home loan borrowing rates.”

Verdict: This probably is, or maybe was, the most widely held myth.

The RBNZ does not set home loan rates.  Most home loan borrowers will have realised this over the past year. If they have not, they must think that the banks are somehow breaking the rules.

The home loan rates are set by the individual banks (and here I include the credit unions, building societies and mortgage brokers).  Governments and politicians, for example, might all at one time or another apply pressure on the banks to move their interest rates, but they don’t make the call in New Zealand’s de-regulated market.

The banks make the pricing decision based on their cost of funding loans, their cost to deliver and service loans, their required return on shareholders’ funds, and the competitive state of the market.

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“The home loan contract is one of the strangest contracts you will ever agree to.”

Verdict: This one is not a myth.

When you sign a contract to rent an apartment or build a house, buy a car, sign up to a phone plan, or for almost anything else, you sign up for the service for a price fixed for the term of the contract.  This is not so for a floating rate home loan, where you sign up to repay the loan over 25 or 30 years, but the price (the interest rate) and therefore the repayments can change, at the bank’s option.  It’s even true for fixed rate loans, where the rate remains steady during the fixed term, but then reverts to floating.

So, why does a floating rate home loan not fit the norm?  It’s because the term of a home loan has to be very long in order to allow it to be affordably repaid.  This means that the bank has to fund the loan every year for its 25-year life, and it is not possible to viably fix the funding cost for that long.

Think of how it differs from buying a car.  With a car, the manufacturer builds the car at a cost overseas, and it is imported and wholesaled to a dealer who sells it to you.  On the way, all of those parties have incurred their costs upfront and applied their margin, and it is sold to you for a price that covers all that.  The parallel with a home loan is that the bank has to fund the loan again every year or two, so their cost of manufacturing is effectively ongoing for the full 25 years of the loan.

Hence the floating and one-sided nature of the home loan contract.

Magnifying Glass

“The banks should pass on the full amount of a RBNZ cash rate decrease, every time.”

Verdict: Sorry, another myth.

In a world where all costs are directly and equally impacted by the RBNZ cash rate, this could possibly be the case.  But we don’t live in that world.

The bank has costs in delivering the loan to you and in providing ongoing administration and reporting to you.  These bear no relation to the cash rate.

The bank has to earn a return on its loan if it hopes to stay in business and pay shareholders a dividend.

The big item in the equation is the funding of the loan, which again is only partially related to the cash rate.   Deposits raised from New Zealand customers’ deposits are only part of the mix; financial institutions serve a local market but are affected by global factors, such as an increase in the cost of international borrowing.

In the current low interest rate environment, New Zealanders put less energy into savings and more into property, CANSTAR New Zealand general manager Jose George says.

“This means New Zealand’s financial institutions have had to increase their borrowing from overseas to support our lending demand. The knock-on effect is that mortgage rates will continue to rise.”

The country’s borrowing costs are also affected by New Zealand’s sovereign credit rating and the bank’s credit rating, market conditions in international debt markets, exchange rate changes, liquidity in markets etc. In particular, where funds are raised overseas, they bear only peripheral relationship with RBNZ cash rate moves.

In short, the RBNZ cash rate signals the direction of the likely movement, but the mix of a bank’s funding sources and costs is what leads banks to determine how much they can pass on to borrowers.

Magnifying Glass

“All institutions are faced with the same cash rate change and should pass on the same amount.”

Verdict: Another myth.

Life is not that simple.  Every lender has a different cost structure, made up of the mix of costs and funding sources outlined above.

At times, this might favour the big banks who have economies, because of the size of their home loan book and because they raise funds in wholesale markets, which are sometimes more cost effective.

At other times, it might favour the credit unions, which rely more on deposits from New Zealand customers.

Still other times, the mortgage originators, which raise their funding through loan securitisation (think on-selling their loans), can come out on top.

Pricing pressures are going to favour these groups differently at any one time, and mean that they will sometimes be passing on a different proportion of an RBNZ cash rate cut.

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“Consumers are powerless when faced by a bank interest rate increase and just have to pay more.”

Verdict: Very much a myth.

Here at CANSTAR, we compare the home loan market on our website, displaying a massive range in rates and charges and also in the features the providers offer. It has never been easier to compare and switch.

The range in floating rates on offer for a residential home loan goes from 5.55% per annum up to a maximum of 5.90% per annum. The average rate is 5.74%.  That means there is a 0.35% difference between the minimum and maximum rate – it might not sound like much, but you’re dealing with big numbers when it comes to home loans!

The range in 3-year fixed rates for a residential home loan goes from 5.09% per annum, up to a maximum of 5.49% per annum. The average rate for a three-year fixed residential home loan is 5.28%. In this case there is a difference of 0.40%.

Most people are in a position to switch loans and could make significant savings amounting to thousands of dollars per year.

Consumers shouldn’t be tied down by loyalty or laziness. They have the power to switch and save!

If you are in the market for a new home, check out our comparison tables below. These have been sorted by current rate (lowest to highest) and display the current market offerings for first home buyer loans for both floating and fixed options in Auckland for a loan of $750,000.

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Canstar is an information provider and in giving you product information Canstar is not making any suggestion or recommendation about a particular product. If you decide to apply for a home loan, you will deal directly with a financial institution not with Canstar. Rates and product information should be confirmed with the relevant financial institution. Home Loans in the table include only products that are available for somebody borrowing 80% of the total loan amount. For product information, read our detailed disclosure, important notes and additional information. The results do not include all providers and may not compare all the features available to you. Canstar may earn a fee for referral of leads from the comparison table. See how we get paid.

The Star Ratings in this table were awarded as per our most recent rating. View the Canstar Home Loan Star Rating Methodology. The Star Rating shown is only one factor to take into account when considering a product.

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