What really determines your mortgage rate

In a surprise move the Reserve Bank has held the Official Cash Rate steady at 2.75%, when most economists were expecting a 25 basis point hike. But for homeowners waiting to see what the decision means for their mortgage, the answer appears to be becoming increasingly complicated. That’s because a change or hold in the OCR hasn’t necessarily been translating to an equivalent change in retail interest rates, and in recent months, mortgage pricing has often moved well before the Reserve Bank has made its decision.

For years, homeowners have typically looked to OCR announcements as a relatively straightforward signal of where mortgage rates might be heading next. The all important rate goes down, mortgage rates follow or if it goes up, borrowing becomes more expensive.

While that relationship remains important, Infometrics Principal Economist Brad Olsen says its been far less direct this year.

“Markets, including mortgage markets, moved so much earlier than the Reserve Bank itself, so by the time the official cash rate went up, most people’s mortgages were already reflecting everyone’s expectations of that OCR hike.”

That means waiting until OCR day to work out what is happening with mortgage rates can leave borrowers looking in the rear-view mirror.

How the OCR influences borrowing costs

The Official Cash Rate is the interest rate set by the Reserve Bank of New Zealand and is one of its primary tools for influencing economic activity and inflation.

At its simplest, Olsen says it can be thought of as a short-term cost of money for banks.

Banks hold money in settlement accounts with the Reserve Bank to facilitate payments between financial institutions, with the OCR effectively setting the overnight interest rate around those balances.

Because it’s an overnight rate, it has the strongest influence over very short-term borrowing costs.

“It is very much an overnight account rate, and because of that, that’s why it influences the short term so much. It’s why it dictates your floating mortgage rates.”

But most New Zealand mortgage borrowers don’t have a floating loan. They’re either choosing between six-month, one-year, two-year, three-year and sometimes longer fixed terms.

And the further out borrowers go, the more other factors start to matter.

Why fixed mortgage rates can move early

One of the biggest changes for borrowers to understand is that financial markets are constantly trying to predict what happens next.

Banks don’t necessarily wait for the Reserve Bank to increase the OCR before adjusting mortgage rates.

“If financial markets become convinced an increase is coming, wholesale interest rates can rise and banks may reprice their lending weeks or even months before the Reserve Bank acts.”

That’s particularly relevant for fixed mortgage rates.

Shorter-term lending remains heavily influenced by the OCR, but longer-term fixed rates are more affected by wholesale swap rates and bond yields, which incorporate expectations about where inflation and interest rates might sit several years into the future.

“Your six-month, one-year rates and your floating rate definitely will be influenced by the OCR. However those longer rates, if you’re looking three, four or five years out, will be influenced by what people’s expectations are for inflation, interest rates and similar in a couple of years’ time.”

It explains why mortgage rates can sometimes increase before an OCR hike.

Olsen says there have already been examples this year where markets priced in more OCR increases than ultimately appeared necessary.

“Sometimes banks will move pre-emptively. Sometimes it’s months ahead of an OCR decision. Sometimes it’s just a couple of days if they’re pretty sure of where the direction of travel is going,” he says.

So an OCR increase does not automatically mean borrowers should expect another immediate 25 basis point increase in their fixed mortgage rate. Some, or potentially all, of that expected move may already have been priced in.

How wholesale rates flow through to mortgages

For borrowers trying to make sense of the system, Olsen says it can help to think of interest rates as several interconnected layers.

At one end sits the OCR, which heavily influences the short-term cost of money.

Then there are wholesale swap rates and bond yields, which reflect expectations about future borrowing costs, inflation and economic conditions.

Finally, there are the retail rates offered to households.

Banks take into account what it costs them to obtain funding and then apply their own lending margin, risk assessment and commercial considerations before arriving at the mortgage rate offered to customers.

Whatever banks pay for their funding, Olsen says, ultimately needs to be factored into what they charge borrowers.

But the pass-through is not always one-for-one.

“There’s a whole range of different things that might influence where your lending rates are,” he says.

International markets matter too.

New Zealand banks operate within a global financial system, which means movements in overseas bond markets, international interest rates and investor expectations can affect funding costs at home.

Inflation expectations also matter because lenders agreeing to a fixed interest rate for several years need to consider what money will be worth, and what borrowing costs may look like, during that period.

Bank competition and borrower circumstances matter

Funding costs are only one piece of mortgage pricing. Olsen says competition between banks can influence not just the headline interest rate available, but which fixed terms lenders choose to compete most aggressively on.

“One bank might offer a particularly sharp six-month or one-year rate to attract new borrowers, while another may be more competitive on three or four-year lending.”

Cashbacks and other incentives can also form part of the overall offer.

“Sometimes it’s going to be rates directly. Sometimes it’s going to be the terms and the periods that are on offer. Sometimes it’s going to be those other incentives as well.”

Borrowers' individual circumstances also make a significant difference.

Olsen says the gap between standard and special mortgage rates can sometimes be around 60 basis points, meaning borrowers with sufficient equity to qualify for a special rate can face considerably different borrowing costs from those who do not.

It means two households watching exactly the same OCR announcement can ultimately face very different mortgage outcomes.

Focus on affordability rather than predicting the OCR

For homeowners approaching a refix, the increasingly complex relationship between the OCR and retail rates makes trying to perfectly predict the next Reserve Bank decision a difficult strategy.

Instead, Olsen says borrowers should focus on what they can control.

“One useful exercise is stress-testing household finances against higher interest rates.”

Rather than simply asking whether the bank believes a borrower could continue servicing the mortgage, homeowners can consider what a higher repayment would actually mean for their lifestyle.

“If interest rates went to this level, could I afford it? What would I have to cut back? What would I cut back if it went up another percentage point after that?”

“Doing that work before rates change can help households make more considered decisions about their spending, renovations or other major financial commitments.”

For some borrowers, spreading their lending across different fixed terms may also provide greater certainty.

A shorter term might offer a cheaper rate today or allow a borrower to respond more quickly if rates fall. A longer fixed term might cost more initially but provide certainty over repayments.

“There is no single approach that suits every household. It comes down to risk tolerance.”

What homeowners should watch before refixing

Despite the changing relationship between the OCR and mortgage rates, Olsen says the OCR remains an important indicator.

What has changed is that it should no longer be viewed in isolation.

Economists are also watching inflation, unemployment, economic growth, fuel prices, wage growth, international interest rates, bond markets and wholesale swap rates to understand where borrowing costs might move next.

“There’s a lot to look at.”

“We’re looking a lot at the OCR. We’re looking at what’s happening with GDP, what’s happening with unemployment, with inflation. But we’re looking at so many other things.”

For the average homeowner, monitoring every movement in global financial markets is neither realistic nor necessary.

Olsen says the Reserve Bank's Monetary Policy Statements, released alongside key OCR decisions, can provide a useful overview because they bring many of those competing economic forces together.

Ultimately, though the OCR still matters.

But for borrowers trying to work out what happens next, the headline number is increasingly only the beginning of the story.

Mortgage rates are shaped by what the Reserve Bank does today, what financial markets expect it to do tomorrow, what is happening offshore, the cost of bank funding and how aggressively lenders are competing for customers.

For homeowners approaching their next refix, that means the more useful question may no longer be simply, “What will the OCR do next?”

It is how much uncertainty they are comfortable carrying if the answer does not translate neatly into the mortgage rate they ultimately pay.