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