Money · Credit · New Zealand · Part 22
What happens to bank credit when a loan is repaid?
Bank lending expands the banking system's balance sheet. Repaying principal reverses that process.
Part 2 explained how a bank creates a deposit when it makes a loan.
Now we complete the cycle.
The Reserve Bank states the mechanism plainly:
bank deposits are created through bank lending, and bank deposits are destroyed when customers pay debt back.
Reserve Bank — Money creation in New Zealand ↗
That sounds strange at first.
We are accustomed to thinking that money, once created, must continue moving from person to person forever.
But bank deposit money is a financial liability of a bank.
When the corresponding loan is repaid, part of that balance-sheet structure can simply contract.
A bank loan creates a loan asset and a deposit liability. Principal repayment removes both.
Return to the $800,000 mortgage
Suppose a bank originally lends a borrower $800,000.
At creation, the bank records:
Asset: +$800,000 mortgage loan.
Liability: +$800,000 deposit.
The banking system's assets and liabilities have both expanded.
Broad money has increased because bank deposits count as money used by the public.
Now suppose the borrower later repays $10,000 of principal from money already sitting in a bank account.
The bank records:
Asset: mortgage loan −$10,000.
Liability: customer deposit −$10,000.
The balance sheet contracts.
The $10,000 deposit no longer exists as broad money.
It has not been transferred into a hidden repayment account.
It has been extinguished against the loan.
This is what “money destruction” means
It does not mean somebody burned cash.
It means a bank deposit liability has disappeared from the banking system.
Before repayment:
the customer has a deposit asset,
and the bank has an equal deposit liability.
After principal repayment:
that portion of the deposit is gone,
and the corresponding portion of the bank's loan asset is gone too.
The Reserve Bank's 2023 Bulletin illustrates exactly this cycle: lending creates new broad money, and repayment gradually destroys it as the borrower pays the loan back.
Reserve Bank — Money creation in New Zealand, Bulletin PDF ↗
Creation and destruction are balance-sheet events, not printing presses running forward and backward.
Principal repayment does not make the bank richer
This point matters.
If a borrower repays $10,000 of principal, the bank does not record $10,000 of profit.
Its loan asset falls by $10,000.
Its deposit liability also falls by $10,000.
The bank is simply reversing part of the original credit creation.
The bank earns money primarily through the spread between interest income and its funding and operating costs, plus fees and other income.
Principal repayment is different.
So what happens to the interest?
This requires more care.
Suppose the customer's monthly payment is:
$4,000 principal
and
$1,000 interest.
The customer's deposit falls by $5,000.
But the bank's loan asset falls only by the $4,000 principal component.
The $1,000 interest component becomes income to the bank, subject to accounting for accruals, expenses, tax and other items.
So principal and interest do not follow the same accounting path.
Principal: extinguishes part of the loan asset.
Interest: becomes bank income rather than cancelling the principal asset.
Does paying interest also reduce deposits?
At the moment the customer pays interest from a bank deposit, yes: the customer's deposit balance falls.
That deposit is no longer part of broad money while the amount sits as bank income rather than as a deposit owed to a member of the public.
But this is not the end of the story.
Banks then use income to pay:
interest to depositors and wholesale funders,
employee wages,
suppliers,
tax,
dividends,
technology and premises costs,
and other operating expenses.
When those payments are credited to customers' bank accounts, deposits enter circulation again.
Principal repayment cancels part of the loan. Interest becomes bank income and can later return to the deposit system through bank spending and distributions.
This is why saying “interest is destroyed” is incomplete
There is a narrow accounting moment when an interest payment reduces a customer's deposit liability.
But unlike principal, the payment is not cancelling the bank's loan asset dollar-for-dollar.
It is income.
That income then funds the bank's own liabilities, expenses, taxes, dividends and retained earnings.
The correct way to understand the cycle is therefore to trace the whole bank income statement, not stop at the customer's repayment transaction.
Current New Zealand bank data shows the scale of those flows
For the June 2026 quarter, New Zealand registered banks reported:
$8.427 billion of interest income,
$4.457 billion of interest expense,
and $3.970 billion of net interest income.
Reserve Bank — Banks: Summary income statement, June 2026 ↗
The detailed income statement shows that quarter's interest income included approximately:
$4.795 billion from residential mortgages,
$2.478 billion from business loans,
$270 million from other loans,
$673 million from debt securities,
and $242 million from cash and deposits.
Reserve Bank — Banks: Income statement, June 2026 ↗
Those are flows through banks' income statements.
They are not the same thing as principal repayments reducing the stock of loans.
What happens if the borrower pays from another bank?
Suppose the mortgage is at Bank A but the borrower makes the payment from an account at Bank B.
At Bank B, the borrower's deposit falls.
Bank B transfers settlement cash to Bank A through the payment system.
Bank A receives settlement cash and reduces the loan principal by the principal component.
For the banking system as a whole, principal repayment still reduces outstanding bank credit and broad deposits.
The interbank settlement changes which bank holds the settlement balances.
It does not change the underlying system-wide destruction of the principal-created deposit money.
What if the borrower refinances with another bank?
Now the picture becomes more interesting.
Suppose Bank B creates a new $500,000 mortgage so the customer can repay a $500,000 mortgage at Bank A.
Bank B's new lending creates a new deposit claim.
The payment to Bank A then extinguishes the old loan.
At the system level, one loan has been created while another has been repaid.
If the amounts are the same, the net effect on broad money from those two principal transactions may be roughly neutral, although settlement balances and the distribution of assets and liabilities between the banks change.
This illustrates an important point.
The money supply depends on the net interaction of new credit creation, loan repayment and other changes in bank funding — not on new lending alone.
What if a mortgage is repaid because a house is sold?
Suppose the buyer uses a newly created mortgage to purchase a house from a seller who still owes money on their mortgage.
Part of the buyer's new mortgage creates new deposits.
Part of the sale proceeds may then immediately repay the seller's old mortgage, destroying deposits.
The net change in broad money depends on the size of the new loan relative to the old principal extinguished and what happens to the remaining proceeds.
This is one reason gross mortgage lending can be much larger than the actual growth in the outstanding stock of mortgage credit.
Loan write-offs are different again
Suppose a borrower defaults and cannot repay $100,000.
If the bank eventually writes off the loan, the loan asset falls.
But there may be no corresponding $100,000 deposit liability to remove because the borrower may already have spent the money years earlier.
The loss therefore hits the bank's income and ultimately its equity rather than simply reversing the original deposit creation transaction.
This is exactly why bank capital matters.
Shareholders' equity exists partly to absorb losses when bank assets do not perform as expected.
Early repayment also changes bank economics
From the borrower's perspective, repaying early reduces future interest expense.
From the bank's perspective, the loan asset disappears earlier than expected.
The bank must then decide what to do with the resulting liquidity and balance-sheet capacity.
It might:
make another loan,
buy securities,
reduce wholesale funding,
retain liquidity,
or change its asset mix.
So repayment can create capacity for new lending without mechanically forcing the bank to lend again.
Does a bank need somebody else's repayment before it can make a new loan?
No.
This would take us back to the old loanable-funds misconception.
Banks do not have to wait for $100,000 of principal repayments to arrive before they can create another $100,000 loan.
The Reserve Bank's money-creation work makes clear that bank lending itself creates deposits.
What constrains new lending are the factors we covered in Part 3:
capital,
liquidity,
stable funding,
risk,
profitability,
regulation,
borrower demand,
and the wider economy.
Reserve Bank — Money creation and constraints ↗
This means the banking system is continuously creating and destroying money
Every day:
new mortgages are drawn,
business loans are advanced,
credit-card balances change,
principal is repaid,
loans are refinanced,
loans are written off,
banks issue wholesale debt,
customers move money between deposits and other financial assets,
and banks pay wages, interest, suppliers, taxes and dividends.
The stock of broad money we observe at any point is the result of all of those flows interacting.
This is why “banks create money from nothing” can mislead
The initial deposit is created by balance-sheet entry rather than by transferring an existing depositor's money.
That part is real.
But the loan also creates:
a borrower obligation,
a bank asset exposed to default,
capital requirements,
liquidity requirements,
funding needs,
and a stream of future repayments that can contract deposits again.
So the process is not costless creation of net wealth.
A financial asset and liability are created together.
Banks can create purchasing power. They cannot create the borrower's future income needed to service the debt.
What does this tell us about credit growth?
At June 2026, New Zealand banks had approximately $615.1 billion of gross loans outstanding.
Reserve Bank — Banks: Assets — Loans by sector ↗
That stock grows when new lending and other additions exceed repayments and reductions.
It shrinks when repayments, write-offs and other reductions exceed new credit creation.
So if we want to understand whether bank credit is expanding the economy's purchasing power, the important concept is not only gross lending.
It is net credit creation after repayments and other balance-sheet changes.
A simple repayment map
I would summarise the mechanics like this.
New loan principal → loan asset rises + deposit liability rises.
Principal repayment → loan asset falls + deposit liability falls.
Interest payment → customer deposit falls + bank income/equity rises, before later bank expenses and distributions move money back through the deposit system.
Default/write-off → loan asset falls + bank earnings/equity absorb the loss.
Refinancing → new credit creation and old credit destruction occur together.
My conclusion
The life of bank-created money is not necessarily permanent.
A loan creates purchasing power when the bank creates the corresponding deposit.
As principal is repaid, that part of the bank's loan asset and the corresponding deposit money disappear.
Interest follows a different route because it becomes bank income and is then redistributed through the bank's own payments, funding costs, taxes and profits.
The monetary system is therefore not a one-way machine that only creates money.
It expands and contracts continuously.
Bank lending is the creation side of the credit cycle. Principal repayment is the destruction side.
Next
That immediately raises one of the most persistent questions about bank-created money:
If banks create the principal but borrowers must repay principal plus interest, where does the money for the interest come from?
Part 23 will test the claim that there is “never enough money to repay all the debt”, explain the difference between stocks and flows, show how money circulates through bank expenses and new lending, and separate a genuine debt-servicing problem from a mistaken accounting argument.
Primary sources
Reserve Bank — Money Creation in New Zealand ↗
Reserve Bank — Money Creation in New Zealand, Bulletin PDF ↗
Reserve Bank — Banks: Summary Income Statement, June 2026 ↗