A borrower has a $400,000 mortgage split equally between a 2-year fixed rate at 6.5% and a floating rate currently at 7.2%. If interest rates increase by 1%, what will be the impact on their total annual interest cost?
Correct Answer
A) Increase by $2,000
Only the floating portion ($200,000) will be immediately affected by the 1% rate increase, as the fixed portion is locked in. The additional annual interest cost will be $200,000 × 1% = $2,000. The fixed rate portion remains unchanged until it comes up for renewal.
Why This Is the Correct Answer
Only the floating half, $200,000, reprices immediately. $200,000 × 1% = $2,000 a year more interest. The fixed half stays at 6.5% until its two-year term ends.
Why the Other Options Are Wrong
Option B: Increase by $3,000
$3,000 would mean part of the fixed half was also repriced, but the fixed portion is locked until its term ends.
Option C: Increase by $4,000
$4,000 applies the 1% rise to the whole $400,000, but the fixed half does not change until it rolls off.
Option D: No immediate change
The floating half reprices when the lender moves its floating rate, so the borrower's interest cost changes straight away.
Deep Analysis of This Finance Question
This question tests understanding of split mortgage structures and interest rate risk exposure, fundamental concepts for real estate agents advising clients on financing options. The scenario involves a $400,000 mortgage divided equally between fixed and floating rate portions. When interest rates rise, only the floating portion immediately reflects the change, while the fixed portion remains protected until renewal. This demonstrates the risk management principle of diversified mortgage structures. Understanding this concept is crucial for agents as it affects client affordability assessments, refinancing decisions, and long-term financial planning. The calculation requires identifying which portion is exposed to rate changes ($200,000 floating) and applying the rate increase (1%) to determine the annual impact ($2,000). This knowledge helps agents explain mortgage products and their implications to clients making property purchase decisions.
Background Knowledge for Finance
Split mortgages allow borrowers to divide their loan between fixed and floating rate portions, providing both stability and flexibility. Fixed rates remain constant for the agreed term regardless of market movements, offering payment certainty. Floating rates fluctuate with market conditions, typically following the Official Cash Rate set by the Reserve Bank of New Zealand. This structure helps borrowers manage interest rate risk while maintaining some exposure to potential rate decreases. Understanding these products is essential for real estate agents as they significantly impact client affordability and purchasing decisions. The Reserve Bank's monetary policy directly influences floating rates, making economic awareness crucial for property professionals.
Memory Technique
Think of a split mortgage like a shield that's half-broken. The 'fixed' half (shield intact) protects you from rate arrows, while the 'floating' half (broken shield) lets rate arrows through. When rates increase, only the unprotected floating portion gets hit. Calculate impact only on the exposed (floating) amount.
When you see split mortgage questions, immediately identify which portion is 'shielded' (fixed) and which is 'exposed' (floating). Apply rate changes only to the exposed portion. Draw a simple shield diagram if needed during the exam to visualize the protection concept.
Exam Tip for Finance
For split mortgage rate impact questions: 1) Identify the floating portion amount, 2) Apply the rate change only to that portion, 3) Multiply by the rate change percentage for annual impact. Ignore the fixed portion completely when calculating immediate effects.
Real World Application in Finance
Sarah is considering purchasing a $800,000 home with a split mortgage: $400,000 fixed at 5.5% for 3 years and $400,000 floating at 6.2%. Her agent explains that if the Reserve Bank raises rates by 0.5%, only her floating portion will be affected immediately, increasing her annual interest by $2,000 ($400,000 × 0.5%). This knowledge helps Sarah budget for potential rate rises and understand her risk exposure, influencing her decision on the fixed/floating split ratio.
Common Mistakes to Avoid on Finance Questions
- •Applying rate changes to the entire mortgage amount instead of just the floating portion
- •Confusing which portion is affected immediately versus at renewal
- •Calculating monthly instead of annual impact when the question asks for annual figures
Related Topics & Key Terms
Key Terms:
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A bank checks how much of a borrower's gross income would go on debt repayments. The borrower earns $80,000 a year, already pays $800 a month on other debts, and the new mortgage would cost $2,200 a month. What share of gross income would the repayments take?
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A borrower took out a $400,000 mortgage and has paid $2,200 every month for five years. The balance owing is still exactly $400,000. Which repayment structure is this most likely to be?