What are home loan interest rates and how do they work?

• What home loan interest rates are, and why banks charge them
• How interest rates are calculated
• The difference between fixed and floating rates

Buying a home in NZ usually means taking out a loan to cover most of the cost, with your deposit making up the rest. You're then charged interest on what you've borrowed from the lender, which in most cases is a bank.

Say you're buying at the national average asking price with a 20% deposit:

• House price: $833,800
• Deposit (20%): $166,760
• Amount you borrow: $667,040

Pay that off over 30 years at an interest rate of around 5%, and your repayments work out to roughly:

• $830 a week, or
• $43,000 a year

That covers both the interest and chipping away at the loan itself. Early on, most of each payment goes on interest. As the years tick by, more of it goes towards paying down what you borrowed. 

Seems like a lot for the banks to charge, right? Banks charge interest because lending is their business. When they hand over $667,040 for your house, that's money they can't use elsewhere, and they're taking a risk you might not pay it all back. Interest is how they're paid for both.

Banks pay interest themselves, to the people who deposit savings with them and to whoever they borrow from. They charge you more than that costs them, and the difference is their profit.

To work out your daily interest, your bank takes the amount you still owe at the end of each business day and multiplies it by your interest rate. That figure is then divided across the days in the year.

Each daily charge is added up over the month and applied to your loan at month's end. 

A few things influence how much interest you'll pay:

• How much you borrowed: the bigger the loan, the more interest you'll repay.
• The Official Cash Rate (OCR): set by the Reserve Bank of New Zealand – Te Pūtea Matua, which reviews it eight times a year. When the OCR shifts, it changes the cost of borrowing, which can lead lenders to alter the interest they charge. (See our latest OCR update and when the next announcement is due.)
• How much is left to pay: as your balance drops, you're paying interest on a smaller sum, so your interest payments slowly shrink too.
• The loan term: paying it back over a shorter period usually means paying less interest overall.
• How often you repay: most lenders let you choose weekly, fortnightly or monthly. More frequent repayments lower the interest you pay.

With most home loans in NZ, you'll choose between a fixed or a floating rate. They work quite differently, so it pays to understand both.

A floating rate moves with the wider market. If rates drop, you pay less and can clear your loan faster. But it works both ways. If rates climb, you pay more, potentially more than you would on a fixed term.

The upside: you can make lump sum payments of any size, whenever you like, without penalty.

A fixed rate is, well, fixed. It doesn't budge for the term you've locked it in for, no matter what the market does.

The benefit is certainty: you won't pay more even if rates rise. The flip side is that you can't take advantage if they fall. And if you want to pay the loan off faster than agreed, you may face an early repayment charge (ERC).