Simple economics show when interest rates are lower, people can afford to service a higher home loan, which can help push values up. When interest rates are high, or seem to be tracking higher, people are often more reluctant to spend.

The wider economy also affects house prices because people who are worried about the future of their jobs or their business may be less willing to buy a new home. Banks also become more wary about lending in uncertain economic conditions.

While all sorts of factors affect real estate and housing affordability – from the Reserve Bank’s (RBNZ) monetary policy to the cost of living – the biggest enemy of a stable market is interest rates.

The RBNZ’s Official Cash Rate (OCR), and where it’s going, is the biggest driver of interest rates in the market.

The OCR drives the rate banks pay when they borrow from the central bank, and is the main influence on mortgage and deposit rates.

Expectations of where the OCR is going is translated into government bonds and swap rates (the cost at which a bank borrows at a fixed rate for a set term). The banks borrow from other banks and large financial institutions around the world. These financial institutions charge each other wholesale interest rates to borrow large amounts of money.

When the OCR goes up, the costs to banks go up for their operations and they pass that on to borrowers through mortgage and loan rates.

Mortgage rates will always be higher than the OCR because banks are commercial entities that need to make money – basically their operational margin plus a profit. Although, Infometrics says there is not a one-to-one relationship between the OCR and mortgage rates, especially in the case of fixed mortgage rates.

Fixed mortgage rates can effectively price in future OCR moves ahead of time, meaning that if the RBNZ simply moves in line with market expectations, there might be no change in fixed mortgage rates.

To frame the market dynamic in a different way, fixed mortgage rates are also influenced by movements in longer-term wholesale rates, which reflect a whole bunch of financial market considerations around medium-term expectations for economic growth, inflation and future monetary policy settings.

These expectations evolve over time as new information about the economy becomes available, of which the RBNZ’s monetary policy settings and forecasts are only one part.

‘Recent falls in interest rates have been a tonic’

Confidence Up

Recent falls in interest rates have been a tonic for the housing sector and have brought property investors out of the woodwork after sitting on the sideline for the past couple of years waiting for a sign they would drop.

August’s 0.25 per cent drop in the RBNZ’s OCR – the biggest driver of interest rates – and last month’s supersized fall of 0.50 per cent, with an expected decline of the same magnitude this month, has meant a flurry of investors wanting mortgage pre-approvals.

Mortgage adviser Kris Pedersen, of Kris Pedersen Mortgages, deals mainly with investors and says the rate drops will put a floor under house prices.

“Investors are looking at buying if they can make the numbers stack up or close to stacking up. Only a few months ago they didn’t have that level of confidence because RBNZ Governor Adrian Orr and other economists were still talking about pushing the OCR, and consequently interest rates, up further.

“That ability for investors to now look at a deal and go ‘Okay, if I make the numbers work I’m good’, will bring some confidence back into the sector.”

Squirrel founder John Bolton expects one-year fixed rates to drop below six relatively quickly. “With more aggressive rate reductions in the pipeline, it feels increasingly likely that we’ll receive another 0.50 per cent at the end of November.”

Now, the one-year swap rate (ie the rate at which banks borrow money, which is a factor in how they set mortgage rates) is sitting at about 4 per cent. “But if things play out as expected, we could easily see one-year swap rates down close to 3 per cent by the end of the year, and that would translate into one-year fixed mortgage rates near 5.5 per cent.

“If we see a series of big OCR cuts over the coming months, that will help drive longer-term swap rates back to more ‘neutral’ levels faster, starting to make that a competitive space for the banks.”

Bolton says he wouldn’t be surprised to see three-year fixed rates below 5 per cent either before the end of this year, or sometime early next, which will make that quite an attractive option for borrowers.

“With rates going down again, borrowers need to be both cautious and realistic about their expectations of a ‘good’ rate in the current market. You don’t want to get caught in the trap of using the insanely low rates we saw during Covid-19 as the benchmark for comparison.”

Game Changer

In a bold prediction, Capital Economics Australia and New Zealand economist Abhijit Surya expects the RBNZ to cut the OCR to 2.25 per cent by end of next year – a game changer if it happens.

He says the RBNZ is likely to embrace a more aggressive approach to policy easing as incoming data makes it clear the risks to the bank’s inflation outlook are tilted to the downside.

“The Reserve Bank has always ended up cutting interest rates by more than it anticipated at the start of previous easing cycles. We think this time won’t be any different and expect the bank to cut rates to 2.25 per cent at the end of its easing cycle. That would leave the neutral policy rate well below the 3 per cent level anticipated by the analyst consensus.”

Neutral interest rates matter for financial markets because they help assess the impact of monetary policy and affect the valuation of financial assets based on discounted cash flows.

What’s more, Surya also expects the RBNZ to cut rates at a faster pace than most other central banks, with the OCR reaching its trough by the fourth quarter of next year. By contrast, the analyst consensus thinks rates will bottom out only towards the end of 2026, making the current easing cycle the longest one in modern history.

BNZ chief economist Mike Jones says the bank sees recent falls in mortgage interest rates as more about preventing a deeper correction in house prices than providing the fuel for an immediate lurch higher. The bank is predicting house prices will go sideways in the short term.

It does take some time for interest rate drops to filter through the economy, although borrowers have been fixing on short-term rates of six months to a year recently as expectations of an OCR cut deepened.

In December last year, for example, 36 per cent of new loans by value were taken out for a fixed term of up to 12 months. But that had spiked to 56 per cent by February and reached a new record high of 68 per cent in August – driven by an especially big surge in six-month activity off the back of the first OCR cut in that month.

CoreLogic’s analysis suggests existing borrowers who are rolling over their loans onto a new fixed rate have been behaving in a similar way to new borrowers. RBNZ figures show the share of existing loans that are fixed but due to change (reprice) within the next 12 months has now risen back to about 66 per cent, matching a peak previously seen in the first half of 2021.

The one-year change in the average “special” (high equity) one-year fixed mortgage rate, for example, has recently turned negative for the first time since mid-2021; ie people rolling off a one-year rate from October last year will be seeing their costs fall.

Financial Stress

Some of the available market interest rates have recently dropped below the average rate prevailing across the stock of existing fixed loans for the first time in about three years.

CoreLogic’s chief property economist, Kelvin Davidson, says even though interest rates are now falling, it doesn’t necessarily mean the worst of financial stress has passed for mortgage borrowers. The non-performing loans ratio (loans that are at least 90 days in arrears or regarded as impaired) on banks’ books recently edged up to about 0.6 per cent of existing mortgages, the highest figure in more than a decade.

“They could continue to rise, given the job losses that we’re now seeing,” he says.

‘The non-performing loans ratio on banks’ books has edged up’

Based on RBNZ figures, the trading banks have been raising provisions for possible future “bad” housing loans, to the point where these allowances are now about 40 per cent above even the biggest Covid-era figure.

If mortgages cost more, people can’t borrow as much, and they can’t service as much debt, so that has an impact on housing activity and house price. It’s a sort of inverse relationship; when the OCR goes up, mortgage rates go up and house prices fall/feel the pain, and vice versa, similar to what happened post-Covid.

The cost of borrowing has a strong link on the confidence of existing and would-be borrowers, to make their next buying decision. Davidson says psychology plays a part and when people aren’t as confident about what’s going to happen in the market they tend to offer less and prices fall. When people are feeling bullish and confident and think prices will rise, they tend to rise.

Mortgage payments often make up a household’s most significant monthly expense, so if these are increasing, or borrowers think they are likely to increase further, often spending behaviours change quickly and households adopt a more cautious approach, especially initially as they wait to see how high interest rates may rise and what impact they have on the market.

House prices to income ratios are stretched, meaning houses are unaffordable for most people. The ratio is about nine, but the long-run average is about six, so it’s well above normal.

About 30 years ago that ratio was three; today that’s unrealistic. What that measure misses is the impact of mortgage interest rate falls over time. When mortgage rates were 20 per cent in the late 1980s, borrowers couldn’t take out much debt, so house prices were low in relation to income. As mortgage rates have fallen from 20 per cent to 5, people can afford to borrow more in relation to their income and pay more for a house.

Fact Box

There Are A Range Of Factors That Affect Interest Rates:

• The RBNZ influences interest rates by changing the OCR to either encourage or discourage people from borrowing and spending.
• Movements in overseas financial markets as NZ lenders are often net borrowers from those markets for large amounts of money.
• Swap rates, which allow banks, companies and investors to manage interest rate risk by locking in a fixed interest rate for a specific period.
• How much money is in NZ bank depositors’ savings, term deposits, PIE and other accounts.
• An increase in demand for loans and credit will increase interest rates while a decline in demand for credit will reduce them.
• A rise in the supply of money available to loan will lead to dropping interest rates. That happened when the RBNZ made more money available following Covid.