In another article we covered different types of mortgage structures in relation to how the principal is structured and repaid. For this article we will discuss different types of interest structures and their impact on your loan.

Fixed Rates

A very popular interest structure in New Zealand is the fixed rate. This is due to the fact that they provide security (for the borrower and the lender) and they are often able to be locked in at a lower rate than the variable rate. (Although this is true most of the time it may not always be the case). Even when longer term rates are higher than the short term, lenders will often use the fixed rates to offer ‘specials’ to secure borrowers.

With a fixed rate structure, the loan is most often funded through long term deposits and may be locked in for six months or one to five-year terms. Because the interest rate is locked for the term, the repayments remain the same for that time. This gives a good amount of security to the person borrowing as they are able to plan their expenses and are protected from the risk of interest rate hikes in the short term.

The downside is that this security comes at a cost. Just as this option gives consistency to the borrower, a commitment is needed as the funds have been locked in for a longer specific interest rate. Therefore, an early repayment fee is charged if you break the contract in order to change the rate of interest you are being charged. This is because the lender will need to commit to the rate you initially locked in. The fee is most often the difference between the new refinance rate and the initial fixed rate or a Net Present Value figure based on the loss of income for the remainder of the fixed rate term. So, the risk here is that if the interest rate does fall, you are stuck making higher repayments.

Variable (floating)

Unlike the fixed rate, this structure is funded by short term deposits. And can fluctuate frequently. Historically the variable rate sits slightly above fixed interest rates. You do however have the benefit of being able to increase your repayments or make lump sum payments whenever you like, without limitation.

The risk of this structure is that your repayments are relatively unpredictable and could be significantly high in some periods. Lenders don’t use the variable rate to offer discounts or specials which also means that they are typically higher than fixed rates.

If you are expecting a lump sum of money or an increase in income, this could be a good option to take.

Capped Rate

In order to reduce the risk of increased repayments with an interest rate rise, a capped rate may be introduced. When the interest rates fall, your repayments will be reduced, however when the interest rates increase, the rate you are charged will not go beyond the agreed cap. This will suit a very cautious person wanting to get the benefit of all interest rate scenarios. The downside is that the rate you are charged is higher the current variable rate. So, although it does provide some protection, it comes at a cost.

Split Loans

This option is a mix of the fixed and variable interest rate structures. You may commit a proportion of your loan to a fixed rate and some to a variable rate. This means that the benefits and disadvantages are in some way diminished giving you more certainty.

This option allows you to make some extra repayments to your loan while still having some of your loan on a secure fixed rate. There are still risks associated with interest rate movements.

A ten – year comparison

Out of interest you can see a comparison between the fixed and variable rates over a 10-year period. This chart shows the average new customer mortgage interest rates at the end of the month for registered banks between August 2008 and July 2018.

The next chart is based on the information above. Here you can see a comparison of the average interest rate over the same ten year period as well as the monthly repayments on a $500,000, 30 year loan for each respective rate.

Which one should you choose?

The answer is specific to your individual situation and a loan structure can be built around your needs. To make a decision based on where a person assumes the interest rates are headed would be speculation and not even the experts get this right all the time. This assumption could leave you paying higher than needed interest rates, missing out on the opportunity to make extra repayments or stuck with a big refinance fee.

As a general rule, we would recommend fixing some of your loan on a competitive rate and allocating some of your loan to a variable rate (possibly with a revolving credit facility). This would give you some of benefits of all options while reducing the impact of their associated disadvantages.

To get the full benefit from a mortgage, you will be better off making decisions based on the structure of a loan and suitability to your situation than to focus your attention on where interest rates are headed.

If you have any questions about which of these would best suit your situation, contact us and we will be happy to help. Or try out our calculators to see how these types of loans work with different loan amounts and interest rates.

We're ready to help find a solution for you