What Are Interest Rates?

When you borrow money from a bank, financial institution or other type of lender, they will charge you interest. That is the cost of borrowing money. How much they charge is referred to as the interest rate, expressed as a percentage.

An interest rate of 5% per annum (pa) means you're charged 5% each year that you owe the principal amount – the amount you borrowed before any of it was paid off.

On a home loan or mortgage, you are charged compounding interest. Rather than wait until the end of the year to collect that interest, interest is calculated daily and charged at the end of every month.

Mortgages can be split into fixed or floating rates – fixed rates are set for a predetermined term (often one, three or five years), while floating rates fluctuate during the term of the loan as the lender changes their rates. 

What is a flat interest rate?

A flat interest rate is calculated on the entire loan amount for the full length of the loan. The interest amount is determined at the beginning of the loan based on the interest rate and charged, regardless of how much of the loan you pay off.

For example, if you borrow $100,000 at a flat interest rate of 10% for five years, your interest payments are calculated to be $10,000 each year for five years, regardless of how much of the loan you're paying off each year.

Interest is not calculated on the remaining, unpaid loan balance – it is set as a flat amount at the start of the loan. For this loan, you'd pay a total of $50,000 interest for those five years and the total repayment would be $150,000.

Why are interest rates important?

Interest rates have an impact on several aspects of the economy. As consumers, our willingness to purchase and to borrow are affected by interest rate levels. Higher interest rates may slow consumer spending. This, in turn, slows down demand, which lowers inflation.

On the flip side, low interest rates entice people to borrow and spend more, so they save less. If they're not earning interest on their savings in the bank, they tend to spend more. Which leads to higher consumer demand, helping to drive up inflation.

So interest rates not only affect our willingness to borrow to purchase property, they also influence our spending patterns, which drive inflation and unemployment up or down.

Can you have a negative interest rate?

Believe it or not, some countries do have a negative interest rate set by their central bank. This is done to counter deflation which, simply put, is when prices of goods fall (the opposite of inflation).

It's a monetary policy tactic used to encourage consumers and businesses to spend or invest, rather than save. Sweden's central bank was the first to use a negative interest rate (in 2009), with other countries like Switzerland, Denmark and Japan also using the strategy to stimulate economic activity.

Are Interest Rates Going Up?

It's likely that interest rates will continue to climb. To understand why that is, we look at our economy – and in particular, inflation – here in New Zealand, as well as what's happening globally.

Remember, the interest rates from your bank or other lender are set in response to any changes to the official cash rate (OCR) set by the Reserve Bank of New Zealand. In May '23, the OCR increased by 25 basis points from 5.25% to 5.5%.

Talking about the decision to lift the OCR in May, Reserve Bank Chief Economist Paul Conway said this: "Based on our current economic outlook, we think the OCR will need to stay at this elevated level well into next year because inflation in our economy is still far too high and employment is above its maximum sustainable level."

Conway further explained, "Keeping the OCR at its current restrictive level will bring our consumer price inflation back to within our 1 to 3 percent target range."

Current high inflation in NZ has been caused by a tight labour market, government spending and record low interest rates we saw during the pandemic. Borrowers are now paying the price as our policy makers attempt to lower inflation.

The Reserve Bank does give us hope, however, as Conway says: "Globally, inflationary pressures are easing and we expect inflation in NZ to continue falling from its peak and house prices to continue falling to more sustainable levels."

What impact do high interest rates have?

High interest rates mean the cost of borrowing money is high, which affects our behaviour and consumer spending. Consumers become more price sensitive and shop around for better deals.

The same holds true when you're looking for a good mortgage package or a more affordable way to re-fix your mortgage.

Take a look at the effect of an extra percentage point increase on mortgage repayment amounts. For every $100,000 you have borrowed, broadly speaking, an extra percentage point increase in your interest rate will add another $1000 per year. If you've borrowed $500,000, that's another $5,000 per year. Add on the cumulative effect of compounding interest and the dollars add up.

Do House Prices Fall When Interest Rates Rise?

Rising interest rates can have an impact on house prices as they help determine our willingness and capacity to borrow money. When interest rates are low, buying a property is easier and we see more first-time buyers entering the market. More demand will drive up prices.

Conversely, as interest rates rise, we see fewer new buyers entering the market. Supply may start to outweigh demand, causing a fall in house prices.

Higher interest rates may also cause homeowners who can no longer comfortably service their debt to sell. They may downsize or move to a region with lower house prices. This movement in the market can have some influence on house prices.

A recent International Monetary Fund (IMF) article states: "A rule of thumb based on cross-country evidence is that every 1 percentage point increase in real interest rates slows the pace of house price growth by about two percentage points."

What Home Loan Interest Rate Can I Expect?

As we've stated, interest rates are expected to continue to climb throughout 2023 and into next year. At the time of writing, the OCR was sitting at 5.5%. The main lenders are offering a floating rate around 8.6%, a one-year fixed rate around 6.99%, and fixed rates for three to five years sitting around 6.29%.

There doesn't seem to be a consensus on whether the OCR has peaked at 5.5%. Some economists predict it may go as high as 6% before it comes down again. What this means is that fixed rates could go as high as 7% and floating rates up towards 9%.

If you're feeling uncertain about what high interest rates could mean for you, feel free to get in touch with us. At Lowe & Co we have an experienced team of mortgage advisors who can help you navigate these concerns. Andco Mortgages offer sound financial advice to help buyers and sellers make the most of the current markets.

Whether you're interested in selling your property or are just looking for some expert advice, talk to the Lowe & Co team today.