How mortgage interest works

In this article:

Why it helps to understand mortgage interest

What are interest rates?

Mortgage interest types in New Zealand

How does mortgage interest work?

Why do lenders charge interest?

Can you just pay the interest on a mortgage?

How to save money on your interest

Why it helps to understand mortgage interest

At their most detailed level, mortgage interest calculations can be quite complex. Fortunately, there are online mortgage calculators to do that work for you. However, it’s also important to understand how mortgage interest works, so that you can recognise ways to reduce the interest paid over the life of your mortgage. Below are the main points you should know before you talk to a lender or mortgage adviser.

What are interest rates?

Interest rates are a way of describing the amount of interest you’ll be charged for the money you borrow. They’re written as a percentage, such as 6% p.a. The p.a. bit is short for ‘per annum’, which means per year.

Using these annual percentage rates to describe interest makes it easier to compare one home loan opportunity with another. They don’t tell you the actual amount you’ll pay, just the main number the lender will use for your interest calculations. We’ll get to how that’s done later in this article.

Mortgage interest types in New Zealand

The two main types of mortgage interest are known as fixed and floating (aka variable).

Fixed interest rates

If you choose a fixed interest rate it will remain the same for a set amount of time, known as a fixed interest rate term. Lenders typically offer fixed interest rates for terms of 6 months, 1 year, 18 months, 2 years, 3 years, 4 years and 5 years. The advertised rates for each term will change from time to time, but once you’ve locked one in it doesn’t change until your fixed rate term ends.

Floating interest rates

These interest rates have no set term, so they can increase or decrease at any time. If the floating rate increases, your regular mortgage payments will go up (unless you’re already ahead of your repayment schedule). If a floating rate decreases, you normally have the option to reduce your payments to match or keep them the same and pay off your mortgage more quickly. With a floating rate you’re free to switch to a fixed interest rate at any time.

What are low equity margins?

These can be small percentages added to the standard interest rates if your deposit is less than 20% of the property’s value. A low equity margin can also be applied as a fixed lump sum.

A lower deposit means you have less equity (un-borrowed value) in the property. That means there’s more risk that the lender won’t get their money back if you can’t keep up with the loan payments. The extra interest or fee helps to cover their risk.

What happens when a fixed interest rate ends?

When your fixed interest rate term is about to end your lender will ask what you’d like to do. You can ‘re-fix’ for one of the new fixed interest rate terms or switch to the floating rate. If you do nothing, it will normally ‘roll’ automatically onto the floating rate at that time. You can then change to a fixed interest rate whenever you wish.

Can you get out of a fixed interest rate during its term?

The short answer is yes, but you might have to pay a penalty to cover the lender’s losses. This is usually charged when interest rates have fallen and the lender can’t re-lend your loan for the same financial gain.

The ‘early repayment penalty/charge/fee’ will depend on:

• How much you still owe
• How far interest rates have fallen
• How long your fixed rate term still has to go

It can be a large amount of money, so you should always check with your mortgage adviser before breaking a fixed rate term. Your lender can’t calculate the exact fee until the day you break, but they can give you a good idea based on current interest rates.

What are the advantages of fixed and floating mortgage rates?

Everyone’s mortgage needs are different, so it’s important to get experienced advice to identify the best options for you and your financial future. After talking to your mortgage adviser, you might decide to break your borrowing into two or more chunks, then use a mix of fixed and floating rates. This is called ‘structuring your loan’.

Here are some potential benefits and downsides to consider when you’re thinking about fixed versus floating.

Pros and cons of a fixed interest rate

• Consistent mortgage payments during a fixed rate term can make it easier to budget
• Fixed rates are usually lower than floating rates
• If interest rates rise during the fixed term, yours won’t, but they also won’t go down if rates fall
• If interest rates rise a lot, your repayments can jump considerably when the fixed rate term ends
• You might have to pay a penalty fee if you need to repay or refinance the loan while it’s still fixed
• Your ability to make extra repayments without a penalty is very limited

Pros and cons of a floating interest rate

• If you’re confident interest rates will fall, you can ride them down before fixing at a lower rate
• You’re free to make extra repayments to reduce interest payments and get ahead of your repayment schedule
• You can switch to another interest rate type, loan or lender whenever it suits
• Some potentially useful mortgage products are only available on a floating rate
• Less certainty can make budgeting more difficult
• Floating rates are usually higher than fixed rates

How mortgage interest works

Your regular mortgage payments are made up of interest plus some of the amount you still owe (the principal). To make budgeting easier, your regular mortgage payments are usually calculated to be the same each time, until the interest rate changes.

Interest is usually calculated on the amount you still owe at the end of each day. These amounts are added up to find the interest you pay in each weekly, fortnightly or monthly mortgage payment. The rest of your regular payment has to keep you on track with repaying what you owe (the principal) by the agreed time (maybe 20 years or so).

• For simplicity, let’s say you still owe $100,000 at the moment and your interest rate is 6%, which is 6/100 or 0.06. That makes the interest charged $100,000 x 0.06 = $6,000.
• The 6% rate is per year, so they divide by the number of days in a year, which is 365 (or 366 in a leap year). That means the daily interest charge at the moment would be $6,000/365 = $16.44 a day.
• If your mortgage payments are fortnightly, your next payment would include $16.44 x 14 = $230.16 in interest. The rest of that scheduled payment would go towards repaying what you owe.
• Now the amount you owe is a little less than $100,000, so the next interest payment will be less and you’ll repay slightly more of what you owe as a result.

Why do lenders charge interest?

Banks and non-bank mortgage lenders borrow the money they lend to you from wholesale lenders, investors, and people with savings or term deposit accounts. Your mortgage provider pays them interest and charges you a higher interest rate, so that they can make some money.

The interest rates mortgage providers charge are based on market rates here and overseas at the time. They’re also influenced by the rate at which the Reserve Bank lends to New Zealand’s banks.

Can you just pay the interest on a mortgage?

Yes, sometimes you can. It’s called an interest-only mortgage. You usually need a larger deposit and pay a higher interest rate. Interest-only mortgages come with terms of up to five years and after that you normally have to repay the loan in full, which will still be the same amount you borrowed at the beginning. You might do this by taking out a standard/table home loan (interest plus principal).

How to save money on your interest

Here are some ways to reduce the amount of interest you pay over the life of your mortgage:

• Borrow less to begin with. Obvious, but it can have a big effect.
• Repay your loan as fast as you reasonably can. The big lending banks only market on interest rates. Not many borrowers understand that it’s not the interest rate you pay that matters, it’s the actual amount of interest you pay over the life of your loan. Rather than focusing on a 0.05% rate discount, find ways to pay off the principal early and focus on reducing the loan terms.
• Work with a mortgage adviser or shop around to find the best interest rates whenever you review, renew, re-fix, restructure or refinance a mortgage. It’s always the first step that’s hard and being with the right adviser will allow you to leverage off their knowledge, experience and connections.
• The most important thing in a mortgage is the way it’s structured. Always ensure that the structure aligns with your finances and cashflow.
• Choose weekly or fortnightly payments rather than monthly. You’ll reduce the amount owing a little sooner each time and pay back more each year. If a monthly payment is four times a weekly one, that’s equivalent to 48 weekly payments a year. But there are 52 weeks in a year, so paying weekly means you’ll reduce the amount you owe each year by four extra payments.
• Consider an offsetting home loan for part of your mortgage. This means you can use money in linked bank accounts to effectively reduce the loan balance when interest is calculated each day. Paying your income into an offsetting account and buying things with a credit card (then paying that off at the end of the interest-free period) can help keep your offsetting account balance up for longer.

It’s worth being proactive about mortgage interest

Understanding how interest rates work and working with an experienced mortgage adviser can help you repay your mortgage faster and significantly reduce the interest you pay over the life of your loan.

You can start by using an online mortgage payment calculator to see the huge effect some straightforward small changes can make.