Ashley Church: Could mortgage interest rates drop to zero?

OPINION: If you have a mortgage, you’ll know that mortgage interest rates have been dropping over the past few years. There are a range or reasons for this which I’ll get into in a moment – but the key thing to understand, for now, is that this trend isn’t new. Mortgage interest rates have been on a downward path since the 1980s when they got up over 20 percent. It’s been a steady slide downward since then.

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Before we talk about the why, let’s talk about the how. Mortgage interest rates are the fee, charged by banks to those who borrow money from them to buy property, and that fee is charged as a percentage of the sum borrowed. The level at which that percentage rate is set is determined by three main things: what it costs banks to borrow money from offshore institutions to on-lend to borrowers; the level at which the Reserve Bank of New Zealand sets the Official Cash Rate; and the amount of profit that the banks hope to make on their mortgage business.

It’s the second of these – the OCR – which is mostly driving the cost of borrowing down. That brings us to the why. In New Zealand, the primary role of the Reserve Bank is to maintain price stability by keeping inflation at between one and three percent. The impact of inflation on the Kiwi economy was extraordinarily destructive prior to the 1990s, and the Reserve Bank Act was designed to ensure that this never happens again. It does this by allowing the Reserve Bank to raise the OCR when the economy is strong (therefore, making the cost of borrowing more expensive and dampening demand) and lowering the OCR when the economy is weak (therefore stimulating demand).

Right now, the Reserve Bank is concerned that Kiwis will stop spending and that the economy will stall. This is partly due to the dramatic impact of Covid-19 on economic confidence – although it’s worth noting that this particularly dramatic slide in confidence was already well underway prior to the onset of Covid. This is why the OCR has been quickly dropping throughout the term of this Government – not just since March - a fact which seems to have been conveniently forgotten in the race to blame Covid-19 for our current crisis.

Currently the OCR is sitting at 0.25 percent and Reserve Bank Governor Adrian Orr has given an assurance that it will remain at this level until at least March 2021. But what about after that? If the OCR drops to zero – or lower – could we see mortgage interest rates also drop to zero? Some bank economists think so.

But let’s consider the factors at play.

Banks have to source their money from somewhere, and every time rates drop that gets more difficult to do. While New Zealand is seen as a safe location, overseas institutions aren’t going to risk their funds without a reasonable risk premium. Similarly, if deposit rates for Kiwi savers keep dropping, many of them will choose to put their money elsewhere, which means that the pool of funds available to banks to on-lend will substantially reduce.

In anticipation of this, in its statement a couple of weeks ago, the Reserve Bank indicated that it might be prepared to step in and lend money to banks, directly, at “very low cost”. It would do this as part of its wider program of “quantitative easing” – in effect creating money out of thin air for a while – but this wouldn’t be sustainable for any period of time.

But could this mean that mortgage interest rates could drop to zero?

Probably not. Banks still need to make a profit so there will always be a margin between the OCR and the banks mortgage rates. Currently, the difference between the OCR and the lowest mortgage rates on offer from the banks is about 2 percent, so the OCR would need to get to -2 percent or lower to get retail mortgage rates anywhere near zero.

For all of these reasons it’s my view that mortgage interest rates of zero percent are extremely unlikely – but that there’s a possibility that we could see fixed rates at one percent, or lower, by the end of next year if economy activity (as measured by the Gross Domestic Product figures) hasn’t picked up substantially, before that.

One thing is certain though. Mortgage interest rates are going to stay lower, for longer. Of that, we can be quite certain.

- Ashley Church is a property commentator for OneRoof.co.nz. Email him at [email protected]