Explained: Why are mortgage rates higher than the OCR?

Thursday, 15 August 2024

When it comes to banking, finance, accounting, and all the associated jargon, it’s easy to tune out. Even for me, bonds, liquidity, debentures, and all their cousins haven’t ever floated my boat.

But I have wondered for a long time why mortgage rates are not the same as the official cash rate. The OCR is now sitting at 5.25%. KiwiBank’s 1-year fixed rate is 6.75% and its floating rate is 8.50%, soon to be 8.25%.

What happens to the 1.5% and 3% difference, respectively? Is it a tax? A profit? A fee? Or is it something else entirely?

Historical Trend

It’s been like this for a long time. Over the last decade, interest rates have always been consistently higher than the OCR.

This graph from Opes Partners has collated the OCR and average 1-year fixed mortgage rate from banks between 2004-2024.

It paints the picture perfectly of 1) The OCR’s corresponding effect on interest rates, and 2) the consistent 2ish percent difference between them. The difference is bigger still for both 2-year rates and floating rates.

OCR Basics

When the OCR goes up, so do interest rates. When the OCR goes down, so do interest rates. That’s the power of the OCR and the Reserve Bank uses it to control inflation.

(OCR goes up > mortgage rates go up > people spend more of their disposable income on their mortgages, less of it on everything else, and save more because deposit rates go up too > lower consumer demand > disinflation).

But that doesn’t explain the discrepancy between the OCR and mortgage rates.

Why is there a difference?

Short answer: bank margins.

Long answer: It’s a complex calculation so banks can cover their own borrowing costs, borrowing risks, admin costs, and make a profit.

Even longer answer: outlined below, as simply as I can.

Where do banks get the money they loan to us?

There are three streams of money into our banks.

1. Customer deposits. Anyone with a savings account or term deposit is essentially lending banks their money, which the banks lend out to others. This is the money people and businesses have in their bank accounts, their savings accounts, term deposits, loan deposits, loan repayments, credit card repayments, things called PIEs (portfolio investment entities), and bonds.

2. Loans from financial institutions and other lenders. Banks borrow money from a variety of sources. This money is called “wholesale debt” and typically comes from other large banks and financial institutions overseas. Banks can borrow money from the Reserve Bank, although this doesn’t usually happen in the normal course of business - it’s usually at short notice and there are complex ways to calculate the cost of that borrowing.

3. Shareholders. When you buy shares in a bank, they get your money. It’s called “capital” which is the stake of the bank the owners own.

Those bank-funders want a return

All of those who have given money to the bank want a return on their investment.

1. Returns for customer deposits. Customers demand interest on the money they have in the bank. Banks have to be competitive on their deposit interest rates otherwise they risk their customers moving their cash to another bank with a more competitive rate, which in turn affects the amount they can loan. Interest rates on these deposits are lower than home loan rates because the bank re-uses this money to lend to its borrowers and needs to make money from doing so.

2. Returns for loans from financial institutions and other lenders. Wholesale debt providers get a return too - in the form of wholesale interest rates, usually at rates locked in for a certain term. Because it involves very large sums of money, the banks get good rates - called wholesale interest rates - which are much lower than the home loan rates they are used to fund.

3. Returns for shareholders. Shareholders own the bank and want a return in the form of increased share prices and annual dividends. There are expectations from shareholders for a higher return because their stake in the company acts as a buffer between the bank’s liabilities and assets and is the first to absorb economic shocks. It’s that old chestnut of higher risk = higher return.

Where does the banks’ money go?

So the banks have all this money from these three sources. Where does it go from here? There are 3 places:

1. Home and business loans. This makes up the biggest portion. These are mortgages for people to buy homes, loans to businesses, and credit cards too.

2. Deposit with the Reserve Bank. Each bank registered in New Zealand must have a sizeable deposit with the Reserve Bank. These are called Exchange Settlement Cash Accounts and are in a constant state of flux due to money constantly moving between banks. The reason for the constant flux is everyday transactions - everyone in the economy spending money. For example, say I’m with ANZ and I buy a $3 chocolate bar from the local dairy which banks with KiwiBank, the $3 moves from ANZ’s exchange settlement cash account to KiwiBank’s one. The total sum of the exchange settlement cash accounts at the Reserve Bank is around $55b at the moment. Last year, average daily transactions between exchange accounts was $36.3b - that’s a lot of flux.

3. Liquid assets. Like the name suggests, banks invest some of their money in assets that act like a tap when needed: turn the tap on and cash will come out. These are things like government bonds that can be traded for settlement cash relatively easily. These assets are essentially a battery storing cash flow in case there’s a surge in withdrawals by bank customers or excessive withdrawals over a period of time, and the bank needs cash quickly to make up the difference.

The banks want a return on investment

1. Returns on home and business loans. Just like the bank-funders wanting a return for their money, so do the banks themselves. They charge interest on loans to households, businesses, and credit card holders. These are at higher rates than what the bank has to pay its own funders.

2. Returns on deposit with the Reserve Bank. The deposits banks have with the Reserve Bank in the form of exchange settlement cash accounts also earn the banks interest. That interest rate is the same as the OCR rate.

3. Returns on liquid assets. The return the banks get from their liquid assets is usually lower because they can be accessed quickly, at any time, and are not locked in for a term.

Banking balancing act

Banks are the conduit between those who have money and want a return on it, and those who need money and pay varying fees to borrow it.

The banks perform a mighty balancing act between the incomings and outgoings which are all in a constant state of flux. They are earning interest on their loans, deposits, and liquid assets and that total amount needs to be higher than what they pay their depositors, lenders and owners.

Money coming in must be more than money going out, then some to account for daily running expenses, and profit.

Making a profit isn’t as easy as it sounds. If they put rates up too high, that will see their customers leave or borrow less, which in turn reduces their profit. If their rates are too low, they might not cover all their costs and won’t make a profit.

The answer

That balancing act is the reason mortgage rates are higher than the OCR; they give banks enough wriggle room to administer their borrowing-lending-profitable balance. I’ve just invented this acronym - but it helps to explain the OCR-mortgage rate discrepancy: R.A.P.

Risk. The bank needs to account for risk. Risk in the market as a whole and risk from those it’s lending to. Given most of their money is invested in home and business loans, there is a risk that it might not be able to be paid back. The bigger the loan: deposit ratio, the bigger the risk. That risk makes interest rates higher.

Admin. The banks have bills to pay too. They have staff costs, building costs, tech costs, and all those other pesky costs we all know too well. They have to factor in the cost of running their business. This makes interest rates higher.

Profit. Like any business, banks need to make a profit. It’s healthy for the economy if our banks are healthy. They need to be profitable if they want to keep lending. This means higher interest rates.

All of these things compound and mean the mortgage rates households and businesses pay are always a couple of percent higher than the official cash rate.