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More happy Approved Mortgage Broker Clients!guide to applying for a home loan

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Interest rates, floating mortgage and fixed rate home loans

Normally, we are attracted to the lowest interest rate we can find. However, it is important to take a close look at what some of these options can mean. The following is a summary of the advantages and disadvantages of the different loan structures.

Interest Rates

An interest rate is simply the price paid for using money. The rate that affects the floating rate is the 90 day bank bill rate. The 90 day bank bill rate is influenced by the Official Cash Rate (OCR). This is the mechanism the Reserve Bank uses to influence 90 day bank bill rates. The Reserve Bank's job is to control inflation (changes in the prices of goods and services) by keeping inflation within a 0-3% band. Interest rates are moved up an down depending on how strong the economy is. If the economy is strong and people have more money in their pockets, there is more spending and more demand for goods and services this in turn pushes the inflation rate up. By increasing interest rates the Reserve Bank contracts growth in the economy as businesses then expand less (because they pay more for money) and people have less money to spend due to higher expenses on mortgage rates and the increased cost of credit. Because people have less money to spend this results in less demand for goods and services and therefore this acts to decrease inflation. Likewise, if the Reserve Bank lowers the OCR there will be more money in people's pockets which stimulates the economy.

How to Forecast Interest Rates

Economists

After many years of analysing economic forecasts our experience reveals that they are slightly less reliable than weather forecasts. There are so many economic factors to consider that if one changes then the forecasts quickly become out-of-kilter. For example, the US dollar drops resulting in a lower Trade Weighted Index, this then imports inflation resulting in increased domestic consumption, causing the Reserve Bank of NZ to raise the Official Cash Rate, which forces short-term interest rates up and decreases the demand for credit. If any of these factors change, then the interest rates will change accordingly with all these factors it makes forecasting interest rates with any degree of accuracy very difficult indeed.

This is why we normally suggest placing about 25% of the loan on the floating rate and the remainder on fixed rates for one to three years.

Floating Rates

Floating mortgage rates rise and fall depending on how interest rates are moving. The interest rate to keep an eye out for changing mortgage rates is the '90 day bank bill rate'. There are two important things to remember about floating rates:

  • If interest rates go up, so will your loan repayments. If interest rates go down, then your repayments will drop also. This can be great when interest rates are falling, but can affect your budget when rates go up.
  • If you want to make lump sum payments, or increase your repayments, there is no penalty.

Fixed Rates

Fixed rates allow you fix a rate for an agreed time. This can be from 6 months to 7 years. Important things to remember about fixed rates are:

  • You keep the same repayments for the fixed rate period. This is excellent for budgeting.
  • If interest rates fall, you will have to stay on the fixed rate.
  • Penalties will be charged for early payments, lump sums, or increases in repayments.

Banks can charge a fortune for breaking a fixed rate home loan, especially if interest rates have fallen below what you fixed the rate for. For an extreme example, if interest rates drop by 4% on a five year loan the cost to break the fixed rate would be an astonishing $16,000 for every $100,000 of lending! Therefore we normally recommend that you fix for a one to three year period, particularly due to changing circumstances over longer periods of time.

Split Loans

A split loan has a portion on the floating and fixed rates. Split loans combine the best of both worlds as they:

  • Give a mix of interest rates so any rises and falls will not cause big changes in your repayments.
  • Allow you the flexibility, through the floating portion, to repay lump sums onto your mortgage.
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