On 8th May 2019, the Reserve Bank of New Zealand (RBNZ) lowered its Official Cash Rate (OCR) from 1.75% to 1.5%, the lowest in New Zealand history. That has implications for both borrowers and investors.
The retail banks (e.g. ANZ, Westpac, BNZ, ASB) can fund their lending through deposits from investors, borrowing from other banks including offshore banks and the RBNZ as a last resort if they are short of funds. A change in the OCR typically affects the cost of borrowing for the banks. If the OCR goes up, the cost of borrowing typically goes up and a lower OCR has a downward impact on the overall borrowing costs for the banks. Due to lower borrowing costs, the banks can afford to and have, with the recent change in OCR, lowered mortgage rates.
What should you do if you have a mortgage – The lower mortgage rates present an opportunity to lower the interest you are paying on your mortgage if you are on a floating rate or if your fixed term mortgage is about to expire. It would be prudent to consider maintaining or ideally increasing your overall repayments in dollar terms when you re-finance to lower rates. This will help you pay off your mortgage faster.
To illustrate this, consider a mortgage of $500,000 with a remaining term of 28 years at the rate of 4.5% p.a. fixed 2 years ago. Let’s assume the rate dropped to 4% p.a. For illustration, we have assumed that interest rates will remain at this level i.e. 4% p.a. until the loan is repaid. The table below compares the outcomes of three scenarios.
Before the interest rate is dropped
Repayments are decreased by the reduced interest amount
Repayments are maintained at existing levels
Repayments are increased by $300 per month (the cost of 2 coffees a day!)
|Term of loan||28 years||28 years||26 years||22 years|
|Total Interest paid||$380,251||$331,957||$295,942||$242,135|
Calculator Source: www.sorted.org.nz
As can be seen from the table above, reducing repayments to reflect the lower interest rate in scenario (1) results in around $48,000 less interest payable over the term of the mortgage but the term is still 28 years. Maintaining the repayments under scenario (2) means the loan can be repaid 2 years earlier and saves a further $36,000 in total interest. Increasing repayments in scenario (3) reduces the term of the loan by a further 4 years and saves an additional $54,000 of interest. The above scenarios show how a relatively modest decrease in interest rates together with a commitment to pay off the mortgage faster can save a significant amount of interest, $138,000 in this example, over the term of the loan.
Reducing debt when interest rates are lower not only means the mortgage can be paid off earlier, it also provides some protection against the risk of future increases in interest rates because the amount of the mortgage will be lower. Kiwis are enjoying historically low mortgage interest rates but this golden period for borrowing is unlikely to last forever.
Term deposit rates
Term deposit rates represent the cost to the retail banks for borrowing from depositors i.e. investors. As mentioned above, term deposits represent a primary source of funds that can be utilised by banks for lending. At the time of writing, a number of banks have lowered their deposit rates in response to the change in the OCR.
What should you do as a depositor/investor – Term deposit rates have been at historic lows for a few years now, so a further drop in rates as a result of the OCR is unwelcome for those investors who rely on term deposits for income. According to the Reserve Bank’s household balance sheet statistics, households had $177bn on deposit with registered banks as at December 2018. Deposit holders should consider the opportunity cost of missing potentially higher returns from other types of investments. To demonstrate the impact, let’s assume an investment of a $500,000. The total pre-tax return from a 5-year term deposit at 3.35% p.a. (www.depositrates.co.nz) would be $83,750 over the term of the investment. The same amount in an alternate investment providing a pre-tax return of 5.35% p.a., i.e. just 2% p.a. higher than the 5-year term deposit rate, would provide a total return of $133,750. That is an opportunity cost of $50,000 over 5 years! To get an understanding of other investment options, refer to our article at https://saturnadvice.co.nz/where-to-invest-if-not-in-property/
All else being equal, a decrease in the OCR should depreciate the New Zealand dollar (NZD). This is good for exporters as New Zealand exports will be cheaper in foreign currency terms i.e. more attractive to New Zealand’s trading partners. On the flip side, a lower NZD means that imports will cost more in NZD terms. This means that oil imports may cost more thereby potentially increasing the fuel prices at the pump!
For an investor holding unhedged offshore investments, a lower NZD will increase the value of their offshore investments in NZD terms.
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Note the information provided is not intended to be financial advice and we would encourage you to take personalised advice from an Authorised Financial Adviser before making investment decisions.