Advice matters
How does mortgage interest work?

Are you a first-home buyer exploring your options? Or maybe a homeowner looking at paying off your mortgage faster?

Either way, this guide is for you. Understanding how lenders calculate mortgage interest can help you find ways to save thousands of dollars on interest in the long run. Here’s how it works, according to our SHARE advisers.

Your mortgage payment, explained

Let’s start with the basics. Each standard mortgage payment has two components: principal (the money you’re paying towards what you owe the lender) and interest (the part that goes to the lender at an agreed interest rate).

Usually, the interest portion of your mortgage repayment is initially a lot higher than the principal portion, but it will reduce as you pay down the mortgage balance (or principal, as it is often known as). Importantly, any extra you pay over the minimum required repayment amount will go to reduce the principal, and therefore reduces the total interest you will pay (we’ll return to this shortly).

Why lenders charge interest and what goes into it

Mortgage interest is what you pay in return for borrowing in the first place. The lender uses this money to cover their own borrowing costs and – being a business – to make a profit after they meet all their other costs such as salaries, operating expenses and taxes.

It’s important to note that the money you borrow for your home loan is usually not the lender’s. A large part comes from money deposited with the lender by people or businesses: for the use of this money, the lender pays them interest. Plus, if they can’t obtain money immediately from deposits, banks can borrow it from overseas sources or from the Reserve Bank of New Zealand (RBNZ), which is where the Official Cash Rate comes in.

The Official Cash Rate (OCR) is the wholesale rate at which registered banks borrow money from the RBNZ. When the RBNZ increases the OCR (for example, to slow down inflation), the cost of borrowing money goes up. Banks then pass on some of the OCR increase to savings account holders (increasing deposit rates) and mortgage borrowers (increasing mortgage interest rates). The other way around is also true: when the OCR is low, mortgage interest rates tend to be lower.

In a nutshell, the mortgage interest rate trends largely depend on what’s happening in the economy. But as we said, the OCR is not the only factor in play, and depending on their own calculations, banks may or may not pass on full OCR cuts or increases.

Fixed vs floating rates

Now, let’s take a closer look at what mortgage interest looks like for you.

With most types of mortgages, you can choose either a fixed-term or a floating (also known as ‘variable’) interest rate. You may also choose to split the amount you borrow between two or more loans, each with its own interest-rate type and term.

  • Pros and cons of a fixed-term interest rate

Fixed-term interest rates give you the certainty of knowing the exact amount of each repayment during the fixed term. Usually, the longer the term, the higher the interest rate (compared to rates for shorter fixed rate terms), as you pay for the longer certainty.

On the flipside, you can usually only make extra repayments up to a certain limit or amount without being charged an early repayment fee. This is important to consider if you want to pay off your mortgage balance faster or if you sell your home while on a fixed-term interest rate.

  • Pros and cons of a fixed-term interest rate

Floating (or variable) rates are usually higher than fixed-term interest rates and are immediately affected by OCR changes – which makes them quite unpredictable. On the other hand, you usually have the flexibility to make lump-sum repayments of any size at any time without penalty.

So, which one is for you? As we’ll see shortly, you can get the ‘best of both worlds’.

Choosing the right mortgage structure

One size doesn’t fit all. The right mortgage structure for you depends on your needs, goals, and financial circumstances.

Some people opt to have a portion of their mortgage on a floating rate (to be able to make as many extra repayments as possible), and the remainder on one or more fixed-term interest rates. For example, you may fix part of the loan for 12 months at a certain rate, and part for 24 months at another.

It’s all about your plans and how much certainty and flexibility you need from your mortgage. The key thing is to choose a mortgage structure that allows you to pay the loan off as fast as possible, if you are in a position to do so.

The importance of paying off your mortgage faster

Mortgage interest can add significantly to your monthly payments, and over the life of your mortgage. To give you a practical example, if you repay a $500,000 mortgage over 30 years at a 5.5% interest rate, with a minimum fortnightly payment of $1,310, your overall interest costs will amount to $522,021.

The solution to this is paying more than the minimum amount or making lump-sum payments where possible: anything extra you put towards your mortgage reduces the amount you owe, and therefore the total interest that will be charged.

Using the previous example, if you pay an extra $100 on top of your $1,310 minimum fortnightly payments, the total interest paid over the term of the mortgage will drop by $95,888 to $425,629. And you will pay the mortgage balance off 4 years and 8 months earlier than scheduled.

With interest rates increasing, there’s never been a better time to focus on repaying your mortgage faster. Not quite sure where to start? Check out our recent guide, and get in touch if you have any questions. We’re here to help.

Always in your corner

Our SHARE advisers know the lending market inside and out. While we can’t tell you where mortgage rates are headed, we can provide you with practical advice on how to structure your home loan to your needs and get mortgage-free faster. Please don’t hesitate to contact us.

Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure accuracy and reliability, the information provided is subject to continuous change and may not reflect current developments or address your situation. Before making any decisions based on the inf