Coping with lower term deposit rates
Over the past week, term deposit rates have fallen across the board. Some by as much as 0.45% over the 4 to 5 year period. This slashes the income you could earn over that many years going forward.
What set it off?
In early May the Reserve Bank of New Zealand (RBNZ) reduced the headline interest rate (called the overnight cash rate, or OCR) to an historic low of 1.5%. This is the first interest rate cut the central bank has initiated since November 2016.
Consequently banks have slashed their term deposit rates across a swathe of products.
What does this essentially mean for your savings and investments? We will cover off the impact of this event one product at a time.
What is the OCR?
The simplest way to think of the OCR is that it’s the interest rate that banks have to pay to borrow money. When the OCR moves up, the banks pay a higher interest rate. When the OCR moves down they pay a lower interest rate.
Banks may borrow from a number of sources. The OCR is the rate at which they can borrow from other banks.
How term deposits work
When you invest in a term deposit you are essentially putting your money at the bank’s disposal. In return the bank agrees to pay you back a fixed amount, over a certain period of time.
For e.g., consider a 5 year term deposit of 3.5%. The money you invest in that term deposit is at the full disposal for the bank’s use for a period of 5 years. During that time the bank promises to compensate you for the use of that money at a rate of 3.5% p.a.
The bank now has your money at its disposal to deploy on its own terms as explained above. The bank makes a profit if it is able to deploy that money and earn more than the 3.5% it owes you. Banks often penalise you if you withdraw your term deposit prior to that term maturing. Essentially they are charging your for making the money unavailable for the remaining period of the term.
The impact of falling rates
At its peak, the OCR was 8.25%, which was in the 2007/2008 period.
Today the OCR stands at 1.5%. That’s a reduction of 6.75% over a decade. When the rate you can earn on term deposits fall, the income you derive from these type of products get slashed as well.
This can be particularly painful for those with large holdings of term deposits in their portfolio. Typically, retirees would rely on these types of income based products. Relatively, riskier assets like shares are often better suited to grow in value over time, rather than generate income.
A cut of 6.75% over a 5 year term translates to a fall in income earned of $33,750! 10 years ago you could have locked in a term deposit that would have earned you $33,750 more than what you could possibly earn from a similar term deposit product today.
If you rely on your investment portfolio for income, you would be well placed to consider other options in a falling interest rate scenario.
In the meantime, check up on our easy-to-use comparison tool for your best option for term deposits here.