The majority of banks in New Zealand all compete for your business fighting over which has got the cheapest interest rate. You’ve probably experienced or seen this all the time. 

All this attention on interest rate makes you believe these are the most important things to consider when getting a loan to buy a home or investment property. 

Well, I’m here to tell you this is often WRONG! 

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Here’s why

The problem with only considering cheap home loans is they can end up costing you much more in the long run compared with other loan structures. 

While it may seem like a good idea to have a super-low interest rate, it’s not necessary the best way to go, and you may find yourself in a financial trap down the track. 

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Examples

Let’s say you want to buy a property for $500,000. 

You need a loan of 80%, so the loan amount is $400,000. You research the cheapest rate and find out the rate for one year is 4.50% and two year is 4.60%. Because you believe ‘the cheapest is the best', you fix the entire loan for one year, but when it comes off the one year term, the interest rate jumps to 5.00%. You would be better off if you fixed your loan for two years. 

Another example, let’s say you are a property investor with six rental properties and total loan size of $4m. 

The 1-year rate is 4.50%, and five-year rate is 5.60%. 

On the surface, you probably think it would be crazy to fix the loan on a 5-year term when one year rate is so much cheaper, so you go with the lowest rate approach by fixing for one year. 

Six months later, due to some unforeseen circumstances, interest rates on all terms go up significantly by 2%. You have to pay $80,000 additional interest costs per year, but you are unable to recover it from the increase of rental income (to make breakeven, you have to increase rental income by $256 per week for each of your six rental properties). Can it be easily achievable? 

Because of the negative cash-flow problem, unfortunately, you are forced to sell some properties to pay down debt to a more manageable level. Due to the bottom of the property cycle, as well as the forced sale, you lost equity which was built up over the last few years. 

Your wealth has suddenly dropped by half a million.

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Solution

These two simple examples show why only focusing on the cheapest rate is not in your best interest.
Instead, you need to understand the overall picture of wealth and assets, including predicting interest rate fluctuation and anticipating your life plans like personal income, assets and changes in family structure etc.

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Future Interest Rates

The downside of applying the lowest rated is the possibility of sharp increase in rate before the current fixed term expiry. You don’t want to pay the cheapest rate right now and then have to pay a premium later, which defeats the purpose of minimising your long term interest costs.

There are several factors that drive interest rates movement.

• OCR – The Official Cash Rate (OCR) is reviewed every eight weeks by Reserve Bank of NZ, and it’s one of the most important factors banks use in setting your home loan interest rates for floating and short and medium interest terms. It can be viewed as funding costs. Generally when the OCR is going up or down, the interest rates are also going in the same direction.
• Deposit rate - Reserve Bank of NZ encourage NZ banks to borrow more from local households deposits and reduce borrowing from offshore to minimise the risk exposure of our banking systems to foreign creditors. Global Financial Crisis is a perfect example of how global events can have huge impact on our borrowing rates.
• Interest margin – interest rate is made up of funding costs and margin. Margin is determined by the bank based on their risk appetite and bank’s probabilities. For example, people who borrow above the standard LVR, have fluctuated income, or purchase commercial property should expect to pay more margin. When the banks are trying to gain market share they will slash margin to make themselves more attractive.
• Wholesale rate – this has more effect on long term interest rate such as three to five-year rates. They are driven by the availability of offshore funding and their lending rate. As at 2017, bank funding raised offshore only comprise 30% of the total bank funding. (Courtesy of interest.co.nz)

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Your Personal Situation and Plan

Like most decisions there are no hard and fast rules - a lot depends on your individual circumstances.

If you expect the income for debt servicing to be lower. or if you expect to have some changes in the next few years like family changes, job changes, travel, health issues or a new business, and you can’t afford an interest rate increase then you may want to consider having offset or revolving accounts to give you as a backup option.

If you want the best of both worlds, one common strategy is to break a mortgage up into several different tranches, and spread the rates across different time periods.

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Personal Risk Tolerance

What is your personal approach when it comes to managing risk? Are you an aggressive or conservative person? – what I mean by this is would you rather know exactly what your repayments are going to be for longer period or are you happy with some volatility?

Before getting carried away by the advertised interest rate, it's best to do in-depth research on the interest rates, considering a possibility of interest movements and making sure all the aspects listed above are taken into account before committing.
A great mortgage broker should be able to give you advice on this. Deciding on interest strategies without facts and proper analysis can be dangerous and costly.

Disclaimer: The content in this article are provided for general situation purpose only. To the extent that any such information, opinions, views and recommendations constitute advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised financial advice. We therefore recommend that you seek advice from your adviser before taking any action.