How do interest rates work?

BIG Plans Admin July 5, 2015 No Comments

If you are a homeowner, or prospective homeowner, then understanding how interest rates work is going to be valuable to you when making financial decisions.  You should have some understanding about them, as they impact you, your family, your job and pretty much most things you do.

Who sets the interest rates?

It is the banks who set the interest rates and they determine what rate they lend money out to borrowers.  There are a number of factors which banks consider when they are setting current rates, and this list is in no means exhaustive, but some of them are;

  • The OCR (Official Cash Rate)
  • Bank reserve requirements
  • What is the lending risk
  • What is the LVR (Loan to Valuation Ratio)
  • The global economy

What is the OCR?

The OCR means the Official Cash Rate and is a term used in New Zealand for the bank rate, and is the rate of interest which the Reserve Bank of New Zealand charges on overnight loans to commercial banks.  In short, it is the wholesale rate to retail lenders.  This then influences the retail rate banks charge borrowers and banks normally follow the trend of OCR whether it increases or decreases.

It is a very important rate to keep an eye on, as this will give you an indicator of whether banks are going to increase or decrease their interest rates.  You can see the latest OCR here as well as historic changes.

Bank Reserve Requirements

Banks are required to have capital reserves and although most of the general public may not understand the complexity of these requirements, it does influence banks to make higher margins on lending so they can increase profit, and therefore reserves.

I recall a few years ago banks were making in excess of 2% on their floating rate lending, even while the OCR was moving down, which really displayed to me that they were taking every opportunity to increase reserves.

Banks would have normally followed the OCR, but in that particular period of time, they did not pass on the rate cuts to customers, the increased their profit on floating rate lending.

What is Lending Risk

This is where the perceived risk to the bank may be higher than normal.  For example, interest rates on commercial loans may be higher due to the nature of the loan.  Commercial loans may have a component of speculation and therefore an increased likelihood of the borrower defaulting on the loan in a commercial venture.

This carries much more risk than lending to someone who is borrowing to buy a home to live in, who has a stable job, clean credit etc.  There are more factors to assessing lending risk, but I am sure you get the picture here.

What is the LVR?

This is the Loan to Valuation Ratio and means the loan amount divided by the property value.  For example, if you were buying a $100,000 home and borrowed $80,000 the LVR would be 80%.  Of course, you would be working a miracle if you found a home for $100,000 in major cities and towns!

If your LVR was over 80% then you may be charged an additional margin on your interest rates by the bank.  These rates would most likely go to cover mortgage insurance premiums and maybe a margin for additional risk in lending a higher ratio.

Remember, the banks carry risk on higher LVR loans too.  Let’s say you borrowed $90,000 on a $100,000 home then home values dropped 20%, you would then owe $90,000 on a home now worth $80,000.  I have seen this happen before and it is disastrous for everyone involved.

The Global Economy

We do live in a global economy and are influenced by overseas events and these also determine our currency, OCR and therefore interest rates, so even though we are far from most of the current European crisis with Greece defaulting on their loan, we are not exempt from the impact.

The global economy runs in facts and figures, but also emotion.  It does not make sense to us as times, but we are all interconnected and these events also influence our interest rates.