Swap Rates Explained
Swap rates are not necessarily something that comes up in conversation every day. Unless you are Rupert, in which case you could happily talk about them all day.
But they do have a big influence on fixed mortgage rates. Now, don’t worry, we are not expecting everyone to spend their evenings learning the ins and outs of wholesale markets, but having a general idea of what swap rates are can be useful. Especially when markets shift and the doom-and-gloom headlines start appearing on our screens.
Most people have heard of the Official Cash Rate, or OCR. It gets the headlines and is often the number watched closely by those following the market. Swap rates are not as famous as the OCR, but they play an important role in how banks price fixed mortgage rates. They reflect what financial markets currently expect interest rates to do over different periods.
…So, what exactly is a swap rate?
When a bank offers a fixed home loan rate, it is making a commitment. The customer gets certainty that their rate will stay the same for that fixed period, whether that is one year, two years or five years. But, behind the scenes, the bank still has to manage the cost of providing that fixed rate. The money it lends is not necessarily funded at one fixed cost for the whole term, so if wholesale interest rates rise while the customer’s rate stays unchanged, the bank may end up paying more than it anticipated to fund that lending.
This is where interest rate swaps come in.
An interest rate swap is an agreement between two parties to exchange different types of interest payments for a set period. They are used by organisations such as banks, large businesses with floating-rate borrowing, and organisations issuing fixed-rate bonds. They all use swaps for different reasons, but the aim is usually the same: to manage the risk of interest rates moving.
The swap rate is the fixed rate used in that agreement. So, when people talk about the two-year swap rate, they are referring to the wholesale market rate for fixing interest payments over two years. It is not the mortgage rate a customer receives, but it is one of the key figures banks look at when pricing fixed home loans. The final mortgage rate also includes funding costs, operating costs, capital requirements, risk, margin, and competition between lenders.
Swap rates explained: the difference between swap rates and the OCR
The OCR is set by the Reserve Bank of New Zealand. It influences short-term interest rates and the cost of borrowing between financial institutions. Swap rates are set by the market and can move throughout the day as investors respond to new information and adjust their expectations about future interest rates.
That information can include inflation figures, employment data, Reserve Bank statements, overseas interest rates, bond market movements, and the general outlook for the economy. Because swap rates reflect expectations about the future, fixed mortgage rates can move before the OCR changes. They are not a perfect forecast. They are simply the market’s current view, and that view can change quickly when new information is released.
Why do banks not all move their rates at the same time?
Even when swap rates move, mortgage rates do not always follow immediately.
Banks have different funding positions, deposit costs, lending targets and pricing strategies. One bank may have a stronger appetite for two-year lending, while another may be more competitive in the one-year or three-year market.
Banks may also delay changing rates if they believe a market move will be temporary. This is why two lenders can respond differently to the same change in wholesale rates. Swap rates help explain the general direction of fixed-rate pricing, but they do not determine exactly what every bank will offer. One thing worth pointing out is that floating rates are priced differently because they are not locked in for a set period. They tend to be more closely influenced by the OCR, short-term wholesale funding costs and each bank’s own pricing decisions.
What does this mean for borrowers?
Swap rates are one of the things we look at when helping clients choose a fixed term. They help us understand what the market is expecting, why banks may be pricing terms differently, and why fixed rates can move before the OCR does. Understanding swap rates also helps us anticipate changes to bank pricing before it happens which can be useful when making decisions on fixing your home loan and ultimately help you save money on your home loan.
At Taranaki Home Loans, we combine that information with our own pricing model, current bank offers, loan structure and each client’s plans. We are not trying to predict exactly where rates will go. We use the information available to explain the options clearly and help clients make a more informed decision about what may suit them best.