Most homeowners are familiar with fixed-term mortgages. Over 80% of NZ mortgages are on some sort of fixed-term; the majority are currently for 1 to 2 years. But it’s easy to miss the difference between a revolving credit and a floating mortgage account.
Both revolving credit accounts and floating accounts are priced based on a floating interest rate. This can increase decrease without notice and typically (but not always) moves with the Official Cash Rate (OCR). Here’s an article we wrote on understanding the Official Cash Rate.
As mentioned, floating home loans and revolving credit accounts are priced based on an interest rate that can be adjusted at any time. This rate has, for the last 5-6 years, been 1-1.25% higher than a 1-year fixed term rate. This means if you could fix your mortgage for 2.7% for 1 year, then the floating rate would have been 3.7%-4% approximately.
So why would anyone choose to have either of these accounts? Well, if your mortgage is on a fixed term, there are often break fee costs associated if you make extra payments. Here’s an article and quick video that we have on break fees. Most banks allow some extra payments or lump sum payment (typically up to 5% of the mortgage value) but any more than that would trigger, often very expensive, fees. So, if you were expecting a large sum of money, you may like to have a portion of your mortgage on floating.
Let’s say you were going to receive a $20,000 bonus in 3 months (wouldn’t that be good!). You want to use it to pay down your mortgage so fixing your whole mortgage would just incur break fees at bonus time. A $20,000 account on a floating rate could be created that you can pay, without penalty, when you receive your bonus. You will be paying a slightly higher interest rate on the $20,000 for the 3 months but you will then pay that off and pay no interest from that point on.
But in this example, would you create a floating account or a revolving credit account?
The easy way to remember the key difference between a Revolving Credit and a floating account is to look at the word "revolving". Revolving credit accounts can almost always have an eftpos or debit card attached meaning money can go into the account and be easily spent (a revolving door).
A floating account can have money deposited into it but requires you to manually transfer the money out again (be careful here, see below).
Some banks allow you to transfer any money available in a floating account back out again. Let's say you put your $20,000 bonus into a floating account and then want to buy a car 6 months later. Most banks would allow you to simply transfer the money out but at least one bank requires that you submit a full application to get your money back. This is fine to buy a car but you wouldn't use this account to store a "rainy day buffer" - for instance, some money for if you lose your job. It makes no sense to have a rainy day fund in an account that you need to apply for your money back.
Most banks have a maximum on the limit you can have on a floating-rate (either floating or revolving credit) account. If you have several properties this can be frustrating. We often see investors who have 5 or more properties want to sell a property and put the proceeds from the sale into a floating mortgage. They effectively have this money available to go and purchase another property without notifying the bank.
Oddly enough, it's not the fact that an investor can purchase another property without notification that the banks have a problem with. As long as the investor has good equity, it doesn't technically breach any of the bank's rules. The problem the bank has is that they must always have enough money available to lend assuming all money from a floating account is withdrawn. Let's say an investor had a $1 million floating account and all of it was paid off. The investor is not paying any interest on the money (ie; the balance is at $0) but the bank must have $1m which costs them. Now expand this out to the hundreds of thousands of customers the bank has. It wouldn't take many customers using this strategy before the bank was losing serious money.
Generally, the banks are ok with a floating rate account of up to $250k-$300k but any more than that and they are uncomfortable.
There are 2 main reasons NZers use revolving credit accounts:
Putting your salary into a revolving credit account is a clever way to temporarily reduce interest costs. Interest payments on revolving credits are calculated daily so the moment that your salary lands in your account, the amount of interest for that night is reduced. I have seen this strategy used but you are also at risk of spending your entire salary and not actually quickly reducing your mortgage as much as intended.
Floating accounts are more often used for larger amounts of money that is unlikely to be needed or only needed for one payment in the future. Clever budgeters often use floating accounts to store their tax money (for self-employed workers). You reduce your interest costs by storing the tax money on your mortgage, it is out of your usual spending account and when tax time comes, you can transfer the money back to make the payment (careful of the one bank above that requires an application).
Both floating and revolving credit accounts can be used to significantly reduce your interest payments but choosing the right account for the right job is important.
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