Home Loan borrowing in New Zealand differs from Australia and many countries around the world by the simple fact that the majority of mortgage loans (Around 80%) are on fixed rates while this figure is around 20 – 30% elsewhere. Given this statistic it is probably not surprising that recent cuts in the Official Cash Rate (OCR) have had little effect on lowering the rates offered to home owners. The increased cost of purchasing funds from overseas markets has also restricted lenders abilities to pass on the cuts made by the Reserve Bank. Add to this the low take up rate for bank deposits as people hold onto their money as they face uncertainty over job security, global economics and world politics and you can begin to understand why the Reserve Banks decisions have been so ineffective.
The OCR was established as an economic control mechanism on the back of a major stock market crash in March 1999 which saw Interest rates rise at a phenomenal rate. Whether the rate is cut or not is not the issue for most home owners (At the time of writing the OCR is at its lowest point ever with expectations of further drops later in the year). It’s the resulting changes that the banks make which affect borrowers cash flow, budget and equity position that become much more important. In the same way, the structure of your borrowings as they relate to your personal situation becomes much more important.
So which option is best for you?
In order to decide this, it is important to understand the key differences between the types of loan available. We’ll start with the most common option, Fixed Rate Home Loans.
Fixed rate loans allow for a greater degree of budget control as the rate determined on the day remains the same for the period that the loan is fixed for. This can be for a period of 6 months to 5 years, but it is important to remember that it is a contract guaranteeing the amount you will be required to pay each month and any variations to the payments may incur penalties. One thing that many people don’t realise is that most lenders will allow some additional payments to be made on a fixed loan without penalty, but it is important to discuss with an independent adviser the structure that is going to suit you, as lenders differ on their early repayment thresholds and fees. For example, some lenders will allow you to pay up to 5% of the loan amount each year without penalty while others will allow you to make an increased payment, but only if you maintain your subsequent payments at that higher amount. While the advantage of fixing your rate is the knowledge of exactly what figure you will have to pay each week/fortnight/month, there are also disadvantages with this type of loan. As well documented in the past 6 months, the costs to break a fixed rate agreement can be quite significant and you run the risk of being stuck on a higher rate when the interest rates are falling. Of course it is a swings and roundabouts situation whereby you may find yourself with lower repayments once the interest rates rise. The general rule of thumb is to fix your loan for a short term when rates are high and for a long term when they are low. The current uncertainty of when the economic recovery will begin lends itself to the interesting situation where the Reserve Bank have announced that lower short term rates are expected to stay at their current level for the foreseeable future and many people are taking advantage of the lower shorter term rates to ease their cash flow or get ahead on their loan repayments. Once again it is a good idea to seek advice to determine the best option to gain the maximum advantage.
The second option which is often used by people wishing to reduce their debt at a faster rate is a Floating Rate loan.
Floating or variable interest rates while generally a little higher than fixed rate options (Although currently sitting right in the middle of the short and long term fixed rates) give the flexibility to allow for lump sum payments without penalties, so are ideal if you are expecting a windfall or significant bonus and wish to attack your debt, thereby reducing the length of time and consequently the amount of interest paid.
Floating rate loans can be set up with a regular repayment figure similar to the fixed rate repayments or may be set up as a Line of Credit facility which allows you to put all of your income towards reducing the loan, while paying the interest on the remaining balance. Mike O’Hagan was one of the people working for the company that first introduced this type of product into New Zealand, which was originally designed for commercial use but was adapted to encompass everyday residential borrowers. It is now available under different names (e.g. Orbit, Flexiplus) through every mainstream and many non-bank lenders. It is ideal for reducing debt and costs if managed effectively, but is not for those who find it hard to keep a tight rein on their spending, as we have heard of situations where people have ended up years later with a loan the same size as when they started despite all the money they’ve put towards repayment.
It doesn’t even have to be an either/or situation regarding your Fixed or Floating decision, as often the best way forward is the setting up of a split of 2 or 3 different structures. Talk to a professional who is experienced in handling several options to determine what is right for you. It all depends on how you want to control your finances rather than having them control you.
