If you own a home, or have plans to buy a property at some point, your attention most likely piques when you hear news of an interest rate increase or decrease. You may know that it’s the Reserve Bank of Australia who determines which way interest rates go, or if they remain the same, and you may think that it’s all just about determining how much interest you would potentially pay on a mortgage or other loan. But there’s a whole lot more to it than that, and it’s important to at least understand the nuts and bolts of things so you can then understand how any interest rate changes will affect you. Keep reading so you know what you may be in for next time you hear about an interest rate change.
Who is the Reserve Bank of Australia?
The Reserve Bank of Australia, or RBA, is a body corporate entirely owned by the Commonwealth of Australia. It is Australia’s central bank and its main role is to maintain the stability of the country’s financial system. The public face of the RBA, and the reason you most likely hear about them, is through their role in setting the cash rate. The cash rate is announced after each RBA board meeting, which usually takes place once a month, except in January. The RBA also manages Australia’s gold and foreign exchange reserves.
What is the RBA interest or ‘cash’ rate?
Despite some common misconceptions, the RBA interest rate does not dictate the interest rates individual banks set for their loans, whether they are business loans, personal loans or home loans. Instead, the RBA interest rate is that which affects overnight loans in the money market.
How does this affect banks? Because they sometimes need to take out overnight loans to help fund their various transactions. Believe it or not, banks sometimes run out of cash and that’s why they take out overnight loans, which have an RBA interest rate.
So, a low RBA interest rate (sometimes called a ‘cash rate’), in theory, drives further business by banks because they know that if they need to take out a loan to fund their own transactions they won’t have a large interest rate attached to it. If the cost of taking out a loan by a bank is low, then they are likely to take more risks through lending to more businesses and individuals and driving the circulation of money through the economy. Simple!
Whichever way the cash rate goes, it can have a significant impact on the price of financial products.
Traditionally in Australia, a higher RBA cash rate has meant higher interest rates on home loans, personal loans, savings accounts, car loans and term deposits, which is great if you’re trying to save money, but not so good if you owe money. Alternatively, a low cash rate in Australia has typically meant low interest rates on these same financial products, which is good news for borrowers, but not so much for savers.
So how does a decreasing interest rate affect you?
Over the past decade, the RBA cash rate has been steadily decreasing. Back in September 2011, the cash rate sat at 4.75%, and it had dropped to 3.5% a year later. Fast forward to November 2020, and the RBA cash rate dropped to 0.10%, which is a historic low.
These ongoing low interest rates have contributed to a surge in house prices around the country and an increase in lender confidence at financial institutions. This lender confidence then allows homeowners to either borrow and spend more on their homes, which drives up their value, or to borrow on their increasing equity, so they can in turn become investors with multiple properties.
But of course, like with anything, the situation also presents risk. With this increase in lending activity, those who are not in the strongest of financial positions may enter into higher risk, if not untenable, financial contracts with their lenders, and could find themselves in financial trouble.
With a decreased cash rate comes increased confidence by the banks to lend money. The risk of this is that if they lend to those who have little money to spare, following their mortgage repayments, not only is there a risk of the loan arrangement collapsing from any unforeseen changes to either the lender or investor but that the investor has little cash flow to spend within the economy.
If you have been saving to get your foot on the property ladder, or to invest further, a decrease in the RBA cash rate may not actually be the best news for you, depending on where you are in your savings timeline. A decreased cash rate usually means a decrease in your savings account’s interest rate return, and less high interest savings account options in the market. If you are nearing your savings goal, however, you may be in the perfect position to enjoy the benefits of decreased loan rates and the confidence of banks and lenders.
If you are an existing mortgage holder, you may expect for any cuts in the interest rate to be passed on to you via your lender’s decreasing mortgage rates. If this happens, you have two options. You can either reduce your recurring mortgage repayments, based on the reduced repayment needed, or keep your mortgage repayments as they were and enjoy the significant savings in your interest costs down the line.
However, a drop in the cash rate doesn’t necessarily mean you’re in for lower interest rates. A decrease in the cash rates will sometimes mean lenders also drop their interest rates to be the most competitive in the market and attract new customers. But instead, recent history has shown that banks will not always pass on these savings, but even increase mortgage rates in answer to new lending regulations as well as surging house prices. Financial institutions may also increase or decrease their interest rates off their own bat at any time, not in response to the RBA’s cash rate announcement. To know exactly whether you will be affected by any interest rate changes, your best bet is to speak to your bank or financial institution.
READ MORE: How does an increased RBA interest rate affect you?
