What is a floating or variable rate mortgage?

Also known as a ‘variable mortgage’ or ‘floating home loan’, a floating rate mortgage has an interest rate that can increase or decrease at any time. That means your regular repayments can also change. The other downside is that floating interest rates are usually higher than fixed rates.

The main advantage of a floating mortgage is it gives you the freedom to make extra repayments without penalty whenever you choose. They’re also popular with people who think interest rates are on the way down.

How does a floating mortgage work?

Your mortgage repayments include paying off some of what you borrowed, known as the principal, and paying interest on the amount you still owe each time. There are three ways this can happen.

A table loan – This is by far the most common option, and the one we’ll refer to for the rest of this article. It gives you consistent regular repayments until your interest rate changes. Initially most of your repayment is interest with only a small amount of principal. As the amount you still owe gradually comes down, the interest gets less so each regular repayment can repay more and more of the principal. Towards the end the amount you still owe drops really fast.

Reducing loan – For this option you repay the same amount of principal (what you owe) each time. As the amount owing steadily decreases so does the interest charged each time. This means your regular repayments will be much higher than with a table loan to start with, but steadily decrease over time. Reducing loans are sometimes chosen by people later in life who expect their income to decrease and want to accelerate their loan repayment in the early stages.

Interest-only loan – These loans usually have a term of just five years or less. Your regular repayments only cover the interest charged each time and don’t reduce the amount you owe. After the agreed term, up to five years, they have to be repaid in full. This can be done by getting a new table or reducing loan. The big downside is you will still be paying interest on the full amount when you start the new mortgage. Interest only loans are mainly used by builders and developers who intend to sell the home and repay the mortgage in full as soon as their work is completed.

How long does it take to repay a floating mortgage?

With any mortgage, you agree to fully repay the loan within a certain time. Known as the loan’s term, it can be up to 30 years. When your loan is on a floating interest rate, you can increase your regular repayments or make a lump sum payment to help pay off your home loan sooner. However, if you want to pay it off later, a lender will have to agree to refinance your loan to a new one.

What are the regular repayments for a floating mortgage?
There are two things that affect your regular repayments. One is the loan term, or how long you have to fully repay what you borrowed. The other is the interest rate, which can change with market conditions. Your lender will use the current floating interest rate and a complex formula to work out your initial fortnightly or monthly repayments for any given mortgage term.
How does the mortgage term affect your repayments?

A longer term will reduce your regular fortnightly or monthly repayments, but it has two big influences on the amount of interest you pay over the life of your loan. The smaller regular repayments mean the amount you still owe doesn’t come down as quickly, so the interest you have to pay each time is higher. The second effect of a longer term is you will be paying interest for years longer.

Here’s a quick example for a $500,000 mortgage at a 6% interest rate and assuming the rate doesn’t change.

TermFortnightly repaymentTotal interest over life of loan
20 years$1,653$359,120
25 years$1,486$465,893
30 years$1,383$578,674

To explore more scenarios, see our handy mortgage repayments calculator.

What happens when interest rates change?

When a floating interest rate goes up your lender will increase your regular repayments to suit. They calculate the new payments the same way they did before, using your original loan amount and mortgage term but the new interest rate. You can see the effect of various interest rate increases by using our mortgage repayments calculator. If the new repayments are more than you can afford, you may be able to bring them down by extending the term of your mortgage, to a 30-year maximum. The other option is to switch to a fixed interest rate for a while. These are usually lower than floating rates and they provide you with some certainty for the length of the fixed rate period you chose. You just can’t make extra repayments until that fixed rate period ends.

When interest rates go down most lenders will give you two options. One is to let your regular payments decrease to suit. The other option is to keep your payments the same and use the extra money to pay off your mortgage faster. The second option is strongly recommended if you can possibly afford to keep your payments the same. That’s because it has a compounding effect. Each time you repay more than required, you further reduce what you owe so are charged less interest. This leaves even more money to reduce what you owe next time. And so a snowball effect begins.

Special types of floating rate mortgages

There are two types of mortgages that can be particularly beneficial for some people. Both of these mortgages are only available with a floating rate.
Offsetting mortgages

These mortgages let you use money in linked everyday accounts to effectively reduce (offset) the amount you still owe on your mortgage. That means you can end up paying less interest and more off your home loan with each regular repayment. It can have a very powerful and ongoing effect. The best approach is to deposit your income into the offsetting account each time, pay for most of your purchases with a credit card then repay that in full at the end of the month. This keeps your offsetting account balance as high as possible and your offset mortgage balance low for as long as possible. As your mortgage interest is calculated on the daily balances, it has a strong effect.

Revolving credit mortgages

Revolving credit mortgages are only recommended if you’re very disciplined when it comes to managing money. They’re like a really big overdraft with a floating home loan interest rate. You can make repayments (deposits) of any amount whenever you choose and borrow up to the agreed limit when it suits. Some have a reducing limit to help keep you on track. Managed well they can be like an offsetting mortgage, but there’s a real danger of being tempted to keep borrowing up to the limit for non-essential purchases.

What are the advantages of a floating mortgage?

Here’s a quick summary of the main benefits people see in a floating home loan:

  • The flexibility to increase your regular repayments or pay off lump sums without penalty whenever you choose
  • The option to reduce your regular repayments back to the necessary minimum, if you’re paying more than you need to
  • You immediately benefit if interest rates go down
  • The option to switch to a fixed interest rate mortgage at any time
  • More home loan types to choose from, such as offsetting and revolving credit mortgages
  • You can switch lenders without paying a fixed mortgage early repayment penalty to your current one

What are the downsides of a floating mortgage?

Floating mortgages don’t suit everyone. Here are the main reasons why:

  • Floating interest rates are usually higher than fixed rates, which means it can take longer and cost thousands more in interest to eventually repay your home loan in full
  • If interest rates increase, your regular repayments will immediately do the same; and although fixed interest rates can also increase those repayments would not change until the end of your fixed rate term, which could be several years away

Can you have more than one type of mortgage?

Yes. Many people do this to achieve the best of both worlds. They split their home loan between a floating mortgage and a fixed mortgage. The floating mortgage gives them flexibility for extra repayments they expect to make. The fixed rate mortgage provides a good level of budgeting certainty and peace-of-mind.

What is the best split between floating and fixed mortgages?

Some people make the floating part an offsetting mortgage to further reduce interest payments. You can also choose more than one fixed rate mortgage. By having them on different fixed rate interest terms, such as a one year fixed and a three year fixed, you reduce the risk of having to re-fix everything when interest rates might be high.

A good mortgage broker has the experience to recommend and explain the best mortgage set-ups for your situation and future goals. They’re paid by the lender you choose to go with, so there’s usually no extra charge for you. Our free Find a Broker service makes it easy to connect with one of New Zealand’s top mortgage advisers from our hand-picked panel.

To learn more

DISCLAIMER: The information contained in this article is general in nature. While facts have been checked, the article does not constitute a financial advice service. The article is only intended to provide education about the New Zealand mortgages and home loans sector. Nothing in this article constitutes a recommendation that any strategy, loan type or mortgage-related service is suitable for any specific person. We cannot assess anything about your personal circumstances, your finances, or your goals and objectives, all of which are unique to you. Before making financial decisions, we highly recommend you seek professional advice from someone who is authorised to provide financial advice.

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