By David Cunningham*
At the top of an interest rate cycle, like where we are now, having your mortgage on a floating rate can be a really smart strategy.
It means that when rates start to fall again, you’re in a position to take advantage of that ASAP, rather than having to wait out the rest of your fixed rate term, or pay through the nose to break early.
Across the ditch in Australia, floating rates are the norm. But in New Zealand, even in the current environment when opting to float can make good sense, less than 10% of all Kiwi mortgages are on floating rates.
Why? Well, the fact that floating rates are consistently so much more expensive than fixed rates is a pretty big deterrent. And the reason for that is simple – it all comes down to New Zealand banks maximising their profits.
Let’s take a look at the key dynamics at play.
1. First, some important context: wholesale markets are currently pricing for interest rates to fall
Wholesale financial markets are where traders put their money on the line.
Right now, New Zealand’s markets are pricing for our Official Cash Rate (OCR) to be about 0.25% lower by July 2024, and 0.70% lower in a year’s time.
It’s a view shared by other markets around the globe. The US, Canada, UK, and other parts of Europe are all pricing their OCR equivalent to have fallen by between 0.25% and 0.75% over the next 12 months.
That’s because these markets are betting we’ll have slain the inflationary dragon by the end of 2024, meaning we should be in a position to ease the tight financial conditions of the last two years.
Expectations of a falling OCR flow through to falls in longer-term wholesale interest rates, often called ‘swap rates’. From their recent peaks, the 1-year swap rate has dropped by 0.4%, while the 2-year to 5-year swap rates have dropped by 0.6%.
Ultimately, those falls should then flow through to fixed home loan interest rates.
(Although we’ve seen the opposite of late, with banks actually lifting their fixed interest rates to widen profit margins.)
All of that is to say that the next move in interest rates should be downwards – and to be able to take advantage of that when it happens, being on a floating rate right now is not a bad idea.
2. Floating interest rates closely follow movements in the OCR – and advertised floating rates are always much higher than fixed rates
When the OCR changes, up or down, floating home loan rates always move in the same direction, and typically always by a similar amount.
Fixed home loans broadly track in the same direction, too, but aren’t quite as closely tied to what’s happening with the OCR.
You can see this in the graph below, which depicts movements in the OCR, floating mortgage rates, and a number of short-term fixed term mortgage rates, back to 2017.
The other thing that’s clearly evident from this graph, is just how much higher floating rates are than fixed rates.
The fixed home loan interest rate that’s most closely correlated to the OCR is the 6-month rate – and yet, even that is consistently at least 1% lower than the floating home loan rate.
The reason for this is because banks seek to extract a much higher margin on floating rates to support their profitability.
3. The good news is that while advertised floating rates are a lot higher than fixed rates, the actual floating rate that many customers are paying is very different
According to Reserve Bank data, Kiwi have about $37 billion worth of home loans on a floating interest rate.
Right now, the average standard floating rate across our five major banks is 8.6%. And yet, the average rate floating mortgage customers are actually paying is about 1.8% below that – at 6.8% - a gap that’s widened from 0.6% five years ago.
The reason for this disparity likely comes down to the number of ‘honeymoon’ deals banks are offering in market.
These might be flood-relief initiatives, special deals for climate-related promotions (such as cheap rates to fund EV purchases or solar panels), or discounts for those customers bold enough to ask.
4. So is opting to float a good idea in the current environment?
If you want to be able to quickly take advantage of falling interest rates when they happen, you’ve got two options:
1) Opt to float, and ask your bank for a (substantial) discount off the carded rate, or
2) Opt for a 6 or 12-month fixed-term
Don’t be afraid of taking a floating rate right now, but make sure you get a discount if you do – otherwise you’ll be supporting higher bank profits. And who wants that?
In an ideal world, the banks will take a long, hard look at their standard floating home loan interest rates, and lower them to a fair level.
Perhaps the Commerce Commission inquiry into competition in retail banking will force that. But then again, perhaps not.
16 Comments
This is an issue we've written a fair bit about over the years. It often seems hard to justify floating rates;
This is market manipulation by the mortgage industry. It is like making bottled water so expensive that you would rather drink sugary soda. Banks can charge the same interest spread on a floating rate product, it will in fact de-risk their interest rate exposure. But it makes mortgages more frictionless and banks don’t like that. I generally believe market forces can correct these things, but this is a case where all banks have colluded to ensure they benefit at the cost of consumers. What stops the Competition Commission from looking into this, this is a cartel-like behaviour.
Don't just bargain on the discount to the rate ... Bargain on how long it stays for. (A minimum of 1 year. Aim for 5 years or more.)
And bargain on the rates applied if you have a revolving credit facility.
Me? I never accept anything less than a 1% discount for at least two years. If the bank doesn't say, "Yes", I get another bank. (Some people I know get even better terms and quite regularly as they have switched enough that the banks know they're not bluffing.)
They are high because that's where captive customers have to borrow, for those who have come off good deals but had a change in circumstances so they cannot change banks or negotiate a favourable deal. Banks bleed their back book dry, that's where the money is made - hence the punitive standard variable.
I've long lamented the lack of competitive tracker mortgage products in New Zealand. People argue they are a bet on rates but what type of mortgage isn't? Fixed rates are equally a bet on rates.
Buying a house itself is a bet on finance and the fact government will never reform the RMA to allow more development.
He has had a lot to say recently … wonder if their massive commission based business model has been struggling? Where does that giant commission come from? Customers. Remind me again what interest rates squirrel charges when it lends out?
It’s very disingenuous to say mortgage rates are driving net interest margins. He well knows it’s the likes of transaction accounts with low-to-no interest that are padding margins when there is a high OCR, just as they suffered when there was a low OCR
RBNZ increases in capital requirement will mean a lift in retail lending rates relative to swaps and OCR in order to keep similar returns.
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