What are Swap Rates?

WHAT ARE SWAP RATES - AND WHY DO THEY MATTER FOR MORTGAGES

Our mortgage brokers often get questions like:

“Why did the fixed interest rates go up when the OCR didn’t change?”
“Why are banks increasing rates when we’ve been told inflation is easing?”
“Why do rates sometimes move before the Reserve Bank has even done anything?”

In most cases, the answer comes back to something that sits quietly behind the scenes but plays a major role in mortgage pricing:

SWAP RATES.

… also known as wholesale borrowing costs. Swap rates are one of the most important drivers of fixed mortgage rates (and thus, your mortgage repayments!) in New Zealand, yet they’re rarely explained clearly.

So in this post, our mortgage broker explains what swap rates actually are, why banks use them, how they flow through to mortgage pricing, where you can see them for yourself online and why they matter more than headlines or forecasts.

THE BIG PICTURE: WHERE MORTGAGE MONEY ACTUALLY COMES FROM

It’s easy to assume banks simply lend out money they already have (mainly customer deposits).
In reality, banks fund home loans through a mix of sources, including but not limited to: customer deposits, offshore borrowing and wholesale financial markets.

When a bank offers a fixed-rate mortgage, it needs certainty about its own funding cost for that same fixed period. That certainty comes from the swap market.

WHAT IS A SWAP RATE? (IN PLAIN ENGLISH)

A swap rate is the interest rate a bank is able to lock in for itself, to borrow money to its customers for a specific period.

The simplest way to think about it is this: A swap rate is the wholesale ‘fixed rate’ that banks pay for money. There are swap rates for different terms, such as 6-month swap rates, 1-year swap rates, and 2-year, 3-year, and 5-year swap rates.

Each swap rate reflects what the financial markets currently expect in terms of:

• Future interest rates
• Inflation risks
• Global economic conditions (including global events unrelated to NZ households)
• Supply and demand for money

Swap rates move frequently, often daily.

WHY SWAP RATES MATTER MORE THAN THE OCR

When it comes to fixed interest rates for mortgages, swap rates matter more than the OCR.

The Official Cash Rate (OCR) mainly influences floating mortgage rates and very short-term bank funding. When a bank prices a 1-year, 3-year, or 5-year fixed mortgage, it isn’t pricing off today’s OCR or the most recent Reserve Bank announcement.

Instead, it looks at:

Where markets expect interest rates to sit over that fixed period.

Those expectations are embedded in swap rates.

This is why:

• Fixed rates can rise - or fall - before OCR hikes, and

• Mortgage rates can change even when the OCR stays unchanged

HOW BANKS USE SWAP RATES TO ‘PRICE’ YOUR MORTGAGE

Here’s the simplified process banks follow:

1. The bank looks at the current swap rate for a specific term (6-month versus 3-year, for example)

2. That swap rate represents the bank’s base wholesale funding cost

3. The bank then adds margins to cover: operating costs, credit risk, capital requirements and profit

4. The result is the fixed mortgage rate offered to borrowers

So while customers see a headline interest rate, underneath it sits a wholesale cost that can move independently of media headlines or policy announcements.

AN EXAMPLE (FOR ILLUSTRATIVE PURPOSES ONLY)

Let’s put some real numbers around this to make it clearer. At the time of writing this post, the 1-year swap rate is approximately 2.68%, but the advertised 1-year fixed mortgage rate (up to 80% LVR) across most major banks is around 4.49%

This means a total margin (between wholesale funding cost and the customer rate) of roughly 1.81% for the 1-year term. That margin covers the bank’s operating costs, their risk and capital requirements and their profit.

Margins aren’t identical across all fixed terms, however. For example: where today’s margin on a 1-year fixed term is around 1.81%, the margin on a 5-year fixed rate at present is closer to 1.78%. And while these margins may look similar today, they’re not fixed or guaranteed.

Bank margins are not static.

Fixed term rates for mortgages don’t always move in total lockstep with swap rates, and some banks appear more competitive on certain terms than others.

This is because while swap rates set the foundation, bank behaviour determines the margin, which determines the final ‘price’ you pay. Banks might shrink their margins to attract new lending/new customers, increase their margins when funding pressures rise, or price aggressively on certain length terms while adding more margin to others.


HOW TO VIEW CURRENT SWAP RATES

Although swap rates sit in wholesale markets, they are publicly visible if you know where to look. One of the most accessible and widely used sources in New Zealand is Interest.co.nz.

They publish regularly updated charts showing: 6-month, 1-year, 2-year, 3-year, and 5-year swap rates. The charts also show historical movements over time.

You can view these charts here: interest.co.nz/charts/interest-rates/swap-rates

This data can provide helpful context around why mortgage rates move, even when nothing obvious appears to have changed. Just don’t use them to try to ‘perfectly’ time’ a mortgage re-fix!

BROKERS’S FINAL THOUGHTS

If you’re approaching a mortgage re-fix, understanding swap rates (and more broadly, what influences bank pricing) is far more valuable than trying to predict exactly what comes next. Certainty is a myth - which is why the best mortgage decisions focus on structure and risk management… as we’ll learn more about in upcoming posts…

YOU MIGHT ALSO LIKE:

• What the heck’s happening with interest rates?
• Let’s talk economist predictions
• Paying a mortgage off faster (for realists)

Our blog is not intended to be taken as personal advice
and is for informational purposes only.
Before acting on this information, contact WealthHealth mortgage brokers
to ensure it is suitable for your circumstances.