How do Banks set Interest Rates

The Reserve Bank of New Zealand (RBNZ) has now raised the Official Cash Rate (OCR) to 5.25% which is the 11th consecutive increase since October 2021 when the OCR was just 0.25%. That’s an increase of 5.0% in less than 2 years.

However, during that time Floating mortgage rates have risen by approximately 3.84% from 4.24% to 8.39% and 2-year fixed rates have risen by 3.95% from 2.50% to 6.45%. Clearly there must be more factors at play than just the OCR that affect how banks’ set mortgage rates.

Lending institutions, like banks, cannot simply magic up money to lend to their customers, they need to source funds to lend out. Rather than plucking an interest rate out of thin air, there are a number of factors that contribute to that rate. These are the main ones:

Official Cash Rate

The Official Cash Rate (OCR) is the main tool the RBNZ uses to influence all interest rates in the economy. When the OCR is hiked higher, interest rates follow, and mortgage rates rise. The OCR is lifted by the RBNZ to cool the economy down and tame inflation. The OCR is reviewed periodically by the RBNZ to ensure it is set at the correct rate for the current economic climate. So, changes in the OCR can influence mortgage rates as they impact the cost your bank will need to pay for loan funding.

Domestic Sources

Banks tend to source about 80% of the funds they need to lend to customers from within NZ. That is, you and I, our savings with the bank as well as the savings of businesses and other institutions. That’s up from about 50% in 2017 and 35% in 2007.

However, banks are not the only place we can deposit our savings. Banks need to compete not only with other banks, but also with finance companies and other non-bank deposit takers. The more interest banks have to pay for these funds the more they will charge you for your mortgage.

International Sources

The other 20% of funds tends to come from international wholesale money markets, their costs of funds is highly dependent on the strength of global economies especially the United States. Competition

There are only so many mortgage customers out there, so lenders will compete for their business. This can have a positive impact on interest rates as banks may adjust those rates in response to what their competitors are doing in order to attract customers.

Economic Conditions

The overall economic state locally and globally can also impact interest rates. For example, NZ is currently experiencing a higher-than-average rate of inflation. The Reserve Bank is taking steps to raise the OCR in a bid to bring inflation back within the recommended range.

Other factors like global interest rates, global financial markets and political events can all impact mortgage rates. As can the economic climate of major trading partners like China, the USA and Australia.

Risk

Lenders will also assess the risk factor of lending to individual customers. They will assess your credit score, income and property value to determine whether you are a high or low risk customer. Customers with a higher risk profile might be offered higher mortgage rates to compensate for the increased risk the Lender takes on by lending funds to you.

Bank Costs

Banks operate as a business and have associated costs to factor in like paying wages, computer systems, complying with various laws and regulation, marketing, and rental. These all add up to the bank’s cost of doing business, and it is all priced into the interest rates they charge. As you can see, there are a number of factors that contribute to the interest rates you pay on your mortgage. They are not simply determined by the OCR, it is only one of a number of contributing factors.