On December 10, 2015, the Reserve Bank of New Zealand reduced the official cash rate (OCR) to 2.5 per cent, 25 basis points below the previous rate.
This is a significant decision for New Zealand, but what exactly is the OCR, and what does it mean for property investors and fund managers?
Who banks for the bankers?
One of the functions of the Reserve Bank is to hold settlement accounts for everyday commercial banks: yes, even banks have banks. These settlement accounts are used to settle obligations with one another. So what exactly constitutes an obligation?
The way the banking system works is like this:
- Michael, who has an account with Bank A, transfers $100 to Mary, who has an account with Bank B.
- Bank A has $1000 in its settlement account, Bank B has $1000 in its settlement account.
- After the transaction, Bank A has taken that $100 from Michael and added it to their settlement account. $1100.
- Bank B, however, has taken $100 from their settlement account and given it to Mary. $900.
- So now Michael has $0 and Mary has $100. On their end, this is all sorted. But Bank B is now owed $100 by Bank A. This is the obligation.
- At the end of the day, Bank A gives Bank B $100 from their settlement account, through the Reserve Bank, so now both banks have $1000 again.
- However, if Michael transferred $2000 to Mary, following the same process, Bank A would not have enough in their account to pay Bank B. So they borrow $1000 from the Reserve bank, and have to pay interest on this loan.
Where does the OCR come in?
The OCR comes in because the rates charged on loans are directly related to it. When the cash rate drops, the banks pay less interest on borrowing.
This encourages more lending because there is less risk for any borrowing they may need to do from the Reserve Bank to meet their obligations with other banks.
This then translates to less risk for borrowing for commercial bank customers as well.
So for property investors, any time the cash rate is lowered, mortgage interest rates lower too. Conversely, any rises will make them higher. The lower the cash rate, the less interest a commercial bank needs to pay on borrowing in order to lend to its customers, so they encourage lending by reducing their own borrowing interest rates.
What does this all mean for the property market?
This boils down to 2015 – 2016 being an excellent time to consider investing in residential property. Banks are already dropping interest rates.
This OCR drop, coupled with new legal measures "expected to reduce housing pressures" according to RBNZ, it is likely that this new cash rate will stimulate the property market with easier borrowing and more spending.
Some banks have reported greater lending than last year even before the cash rate cut. Home and business lending from Westpac increased 6 per cent and 9 per cent respectively from 2014. This increase is likely to continue with the lower interest rates offering fewer risk for greater investment.
But wait, there's more!
The OCR is not the only thing that affects mortgage rates and repayment, however, and is just one of the many tools at the Reserve Bank has at its disposal that can affect the property market. Banks too have multiple different loan types and rates that are affected differently by the cash rate drop.
Your best bet if you are considering taking advantage on dropping mortgage rates is to speak to a qualified expert in order to learn how to build wealth through property investment.
Here's to your financial independence!
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