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.

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Suffice to say term deposits are a popular means of investment for Kiwis!

It’s relatively easy to sign up to a term deposit. You can shop for the best term deposit rate on any given day and fill out some basic details about yourself, transfer money into it and you are set. As much as it might appear to be a straight forward investment, there are still some very important points you should consider when investing in term deposits.

Term deposits are different to your savings account

Both your savings and term deposit accounts are investments held in the form of cash. But, while the cash in your savings account can be withdrawn at any time, your term deposit will typically have a set number of days (called maturity period), before which you can withdraw – this could be 30 days, 90 days, 180 days or any period specified by the bank.

For giving up the ability to withdraw at any time, your term deposit will pay you back more than it would in your savings account. Current term deposit rates vary between 0.5% and 4.2%. Variation in these rates will depend on not only which maturity period you have chosen, but also on which bank you decide to invest with.

You should be aware that there is a lot of merit in shopping around. For example, currently if you decide to invest $10,000 in a 5 year term deposit you could earn anywhere between $2,100 and $1,925 depending on the bank. Shop around!

What happens when your term deposit matures?

At maturity, or when you get to the end of the term you signed up for, you can either choose to reinvest the amount into another term deposit or withdraw your entire balance and invest elsewhere.

Term deposits are not set and forget investments. At maturity it’s a great time to consider whether your personal circumstances have changed or if events occuring in the world mean that you may be earning more from other investments.

The one downside to a term deposit is that your money is tied up for a pre-determined time and if you were to request a withdrawal during the term the bank will put a penalty on you by reducing the interest they pay you. That is a cost to you. So, before you commit to a longer term determine whether you might need to get your hands on that money before the end of the term or not.

Don’t get sold on headline term deposit rates

Term deposits by its very nature are more secure than other investments such as shares. The way term deposits work is that the cash you invest in one is pooled together with those from other term deposit investors, and put to use by the bank to lend to others. The bank then promises a fixed return (interest rate) on your money over the term to maturity. As such, not only do you enjoy a stable ongoing stream of returns but also the prospect of the original amount you put in at the end of the term.

The headline interest rate determines how much your regular payout will be. But, remember because this is an income that you are earning, this amount will be taxed. So the actual amout of money you are left with will be less than what the headline rate implies.

This is different to other investments such as your KiwiSaver fund, returns from which are already taxed within the Fund.

So, if you are comparing term deposit rates with returns from other investments, remember to adjust for your tax rates to make a meaningful comparison.

Find the best term deposit rates on PocketWise.

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