Understanding the cash rate and its impact on home ownership

By Greater Bank
For quite a while now, the RBA Cash Rate has been the furthest thing from our minds.

What with the pandemic, the election, war overseas – it was easy to see why the Cash Rate slipped out of the news cycle.

But, it’s precisely due to these things, as well as other factors that we’re now hearing about it more regularly as it continues to leap higher.

So why should we care?

What is the RBA Cash Rate, and what affects its movements?

And how does that impact you, as the owner of a loan or deposit product? Here’s how.

What is the RBA Cash Rate?
On the first Tuesday of each month, the Reserve Bank of Australia Board meets to determine what changes (if any) are needed to the official Cash Rate.

As the RBA website puts it:

The cash rate is the interest rate on unsecured overnight loans between banks. It is the (near) risk-free benchmark rate (RFR) for the Australian dollar and is also know by the acronym AONIA in financial markets.
Reserve Bank of Australia

Simple, right? Hmmm, maybe not.

In a nutshell, the cash rate represents the interest that banks and lenders have to pay on the money they borrow. I know what you’re thinking – Why would banks have to borrow money? Don’t they have all of our money? We’ll get into this later...

The RBA also defines the cash rate as the “overnight money market interest rate”. This is because banks frequently lend money to one another, and these transfers are processed overnight. The cash rate is the amount of interest banks need to pay in order to borrow money in these transactions.

For a long time now, the cash rate has been in decline (since November, 2011) or stable at a very low rate. In November of 2020 it fell to 0.1%, and stayed there until May 2022, when it rose by 25 basis points (%) to 0.35%. All signs point to more cash rate increases in the latter half of 2022, but don’t panic just yet – in January of 1990 the cash rate was sitting at a whopping 17.50%.

What Causes the Cash Rate to Change?
So, we begin to understand what the cash rate is, but what exactly makes it shift up and down over time?

Generally, when the RBA Board meets to determine the cash rate, the main three factors they take into account are inflation, employment levels and the growth of the Aussie economy.

It’s important to remember that the RBA is not a political body. It operates outside of politics, purely as a financial overseer, and its decisions are not influenced by whichever party has formed government.

Inflation is the degree to which prices of items go up between two points in time. Usually, this is measured quarterly, and is an important indicator of economic performance.

The RBA likes to see inflation in the medium-term sit between a band of 2% - 3%. If inflation gets too high for their comfort, this may be seen as a reason to raise the cash rate.

The theory behind this is that doing so would allow everyday Australians to maintain their purchasing power against the rising price of goods.

If inflation falls below this 2% - 3% band, the RBA may decide to cut the cash rate or leave it stable.

Another key indicator of economic performance is the level of employment/unemployment among Australians.

The RBA might consider lowering the cash rate if the level of unemployment gets too high in their opinion. The reason they might do this is in an attempt to encourage investment and spending in the economy, which may drive job growth and creation, potentially bringing down the unemployment rate.

However, where employment is concerned, the RBA takes more things into account than the unemployment rate.

Despite the fact that unemployment may be low, the RBA may choose to keep the cash rate steady if wage growth is also low. This is because lower wage growth is often associated with poor economic performance and low levels of inflation.

Economic Performance
Economic performance, as it is measured by the RBA, is calculated as a percentage of Australia’s gross domestic product (GDP). GDP represents the total value of all goods and services produced domestically each year.

The RBA may decide to lower the cash rate if economic growth is becoming slower – using this as a way to try and stimulate the economy. We saw a recent example of this during the height of the COVID-19 pandemic, when, the RBA lowered the cash rate to its lowest point in history.

The theory behind doing this is that it may offer incentive for everyday Aussies and banks to spend and borrow money, in turn kick-starting economic growth.

How Does Cash Rate Affect Interest Rates?
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The outcome of the RBA’s monthly board meetings and their subsequent decision on cash rate trajectory is important in the process of financial institutions setting their own interest rates.
However, this is not the only factor considered by banks and lenders when making pricing decisions.

As the RBA puts it – the three factors most banks take into account when setting interest rates are funding costs, competition from other banks and default risk.

Funding costs
Remember earlier, we said we’d get back to the idea of banks borrowing money from one another? Let’s get into it.

All banks have to conduct a delicate balancing act between lending and deposit products (everyday and savings accounts) in order to stay profitable.

Funding costs refer to the rate of interest banks pay when borrowing money to lend out to customers. It also refers to the rate of interest that banks have to pay customers who deposit money with them.

An increase in funding costs (and this is where the cash rate comes in) may trigger some banks to raise their interest rates in order to ensure ongoing profitability. Banks will also be keenly aware, though, that any increase to their interest rates may cause borrowers to be more cautious, potentially borrowing less.

Competition from other banks
The banking marketplace in Australia is fiercely competitive, and lenders know they are competing for your business in order to stay profitable.

This sort of competition also influences the movement of bank interest rates. In order to attract more borrowers and larger loan amounts, banks may reduce their lending interest rates, or alter their lending criteria, in order to provide fewer perceived impediments to potential customers.

The same is true for deposit customers – banks may increase their deposit rates if they are looking to grow this portfolio.

Risk of default
As you might have guessed, or maybe even have experienced, banks pay close attention to the risk associated with any prospective borrower.

By this, we mean the risk of an individual not being able to repay their loan or going into default.

Each bank has their own risk criteria, within which they are prepared to lend, but typically, the higher the risk of default a potential borrower comes with, the higher the interest rate they may have to pay.

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Believe it or not, the RBA Cash Rate has no direct link to the interest rates offered by banks. By this, we mean that banks are in no way obliged to follow suit with the movements of the RBA cash rate.
The cash rate is definitely something that banks keep a close eye on, when making decisions on how to price their own interest rates.

It’s not unreasonable to expect that when the cash rate is low, many banks and lenders will be able to offer lower than average interest rates to new home buyers and people looking to refinance.

It could also be said, however, that when the cash rate is on the website rise, it’s not unreasonable to expect banks to pass on these rises to customers in the form of lending interest rate increases, so the banks themselves can remain profitable for the benefit of their customer base.

How Do Increased Interest Rates Affect Mortgage Repayments?
An overall increase in interest rates from banks can affect mortgage repayments in a number of ways.

Variable rate loans
If a customer has chosen a loan with a variable rate, this means that the interest rate is subject to change at any time. Therefore, a customer with a variable rate loan may be paying an example rate of 2.99% p.a. one month, and then be paying 3.24% p.a. the next month.

This increase in the variable rate will mean an increase in the customer’s minimum monthly repayment as well. Depending on your loan size, this may vary greatly, but in some cases it can be many hundreds of dollars that need to be found each month in order to continue to make repayments.

Reverting to variable after being fixed
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In times of record low interest rates, many lending customers will look to take advantage by opting to fix their home loan for a number of years. Fixing your home loan means you lock in an interest rate for an agreed period of time, ensuring you a secured repayment amount until your fixed term ends, protecting you from variable rate rises.
What we’ll be seeing soon is the completion of many borrower’s fixed terms, and as a result of recent increases in bank interest rates, these customers will revert to a variable rate which will be higher than the fixed rate they had previously been on.

Again, this will result in increased minimum monthly repayment amounts, meaning individuals and families will have to find ways to come up with extra money in order to continue making repayments.

All this is taking place in an environment where inflation and cost of living pressures are on the rise.

How can I Avoid Defaulting on my Mortgage?
No-one intends to default on their mortgage – it’s probably every home owner’s nightmare come true.

However, there are some things we can do to shield ourselves against the risk of home loan default.

If your home loan rate is putting strain on your budget, don’t forget to shop around. While, on the whole, bank lending interest rates are on the rise, it’s still a competitive market. Find a rate that will ease the pressure and a loan that offers features and flexibility to suit your needs.

Offset Accounts
If your home loan offers an offset account option, you should consider putting this to use. Remember, any savings you park in an offset account get subtracted from your total loan amount owing when your bank is calculating how much interest you have to repay.

Lowering LVR
By lowering your loan-to-value-ratio (LVR), we simply mean paying down more of your loan principal than your bank or lender requires. We often call it ‘getting ahead’ on your home loan. By doing this, you not only make extra funds available to you when needed (if your loan offers redraw), you essentially buy yourself time if your regular income stream is disrupted and you’d be otherwise unable to make regular loan repayments.

As we’ve seen, the cash rate of the RBA and its relationship with bank lending interest rates is not as clear cut as people sometimes make out.

Each month (with the exception of January), the Reserve Bank of Australia announces whether the official cash rate will remain the same or move up or down, and this announcement has important ramifications for banks, lenders and everyday Aussies. So what exactly is the cash rate, how does it work, and how can it affect you?

What is the cash rate?
The cash rate is a figure set by the Reserve Bank of Australia (RBA), representing the interest that banks and lenders have to pay on the money they borrow. The RBA itself describes the cash rate as the “overnight money market interest rate”. The reason for this is that banks frequently lend money to each other and process these transfers overnight, and the cash rate is the amount of interest that banks have to pay to borrow money in these transactions.

Current RBA cash rate: 2.35%
At its September 2022 board meeting, the Reserve Bank of Australia (RBA) raised the cash rate by 50 basis points to 2.35%. This follows a series of rate hikes each month this year, beginning from May. This current level marks the first time the cash rate has been above 2.00% since April 2016.

RBA cash rate on the rise again this September

What is the RBA and what does it do?
The RBA is Australia’s central bank, and its role is to make monetary policy and maintain the strength of the nation’s financial system. According to its own charter, the board of the RBA has three key duties. Namely, the bank’s board is required to contribute as best it can to the stability of the currency of Australia, the maintenance of full employment in Australia, and the economic prosperity and welfare of the people of Australia.

One pakenham mortgage broker of the key roles of the RBA board is to set the official cash rate. On the first Tuesday of every month, with the exception of January, the board meets to discuss monetary policy, including whether or not to change the cash rate. At these meetings, it can do one of three things – lower the cash rate, with a view to stimulating borrowing and spending in the economy, raise it to try and keep inflation under control, or keep it at the same level.

How often does the RBA change the cash rate?
Though the board of the RBA has the ability to change the cash rate at each of its monthly meetings, the increase announced in May 2022 was the first change in more than a year. The previous change was back in November of 2020, when the RBA cut it from 0.25% to 0.10%, in an attempt to mitigate the ongoing effects of the COVID-19 pandemic. The cash rate had held steady since then, until the increase to 0.35% in May 2022 which was followed by increases of 50 basis points in June and July.

What’s the RBA cash rate history?
Up until the recent increases, the RBA cash rate had been in decline since November 2011, when the figure was cut from 4.75% to 4.50%. That’s a far cry from some of the highs the cash rate achieved in the last century when it reached its highest at 17.50% in January 1990. It wasn’t until September 1991 that the figure dropped below 10% to 9.50%.

RBA cash rate vs standard variable rate

Why does the RBA change the cash rate?
The RBA takes a number of things into account when considering whether to change the cash rate. Generally speaking, factors that influence the RBA to move the cash rate include inflation, employment, and the growth rate of the Australian economy.

Inflation refers to the increase in price of items from one point in time to another; it is typically measured on a quarterly or annual basis, and is a key indicator of economic performance. The RBA has a medium-term inflation target of 2% to 3%, and if inflation gets too high, it might raise the cash rate to assist Australians in maintaining their purchasing power, as was the case with the 2022 rate hikes. If inflation is below that target range, the RBA may be more inclined to leave the cash rate alone or cut it.

The level of employment is a major indicator of how an economy is performing. If unemployment rates get too high in Australia, the RBA may decide to lower the cash rate, in order to stimulate investment and spending in the economy, which might thereby serve to create new jobs.

But when it comes to jobs, the unemployment rate isn’t the only thing the RBA considers. Even if unemployment is low, the RBA may choose not to raise the cash rate if wage growth is also low, since sluggish wage growth tends to go hand-in-hand with slow economic growth and low inflation.

Economic growth
The RBA states that economic growth in Australia is typically measured as a percentage of the nation’s gross domestic product (GDP) – the total value of all goods and services produced here annually. If economic growth is slowing down, the RBA might choose to lower the cash rate as a means of economic stimulus. This was the case in 2020, when the board set the rate at its lowest point ever in an attempt to mitigate the economic effects of COVID-19. Doing this might, in theory, increase the incentive for consumers and financial institutions to spend and borrow money, which might then set the economy on an upward trajectory.

Does the cash rate affect the banks’ interest rates?
While the RBA’s monthly cash rate announcements are important, and do partly influence how banks and lenders set their interest rates, they are not the only factor that goes into the decision. As the RBA explains it, there are three main factors that can go into how banks and lenders set their interest rates, and decide whether to put them up or down. These three factors are funding costs, competition from other banks for borrowers, and the risk of default from existing borrowers.

Funding costs
Funding costs are the interest rates that banks pay to borrow money (including from each other, which is where the cash rate comes in), and also to the people who deposit savings with them. If funding costs increase, a bank may wish to increase the rates it charges borrowers in order to remain profitable. If lending rates go up, though, borrowers may in turn be more cautious and borrow less. It is therefore important for banks to balance these considerations to maintain profitability.

Competition from other banks
Banks and lenders exist in a competitive marketplace in Australia, and as such, in order to maintain profitability, they must compete for borrowers’ dollars. This competition can influence the movement of interest rates, insofar as banks and other institutions may choose to cut their lending rates (or raise interest rates on savings accounts and term deposits) in order to attract new customers and refinancers.

Risk of default
Banks and lenders are typically concerned with risk, so before lending money to a prospective borrower, they will assess the risk of this borrower potentially going into default or otherwise being unable to repay their loan. If a bank or lender perceives a certain type of lending to be riskier – say, for example, lending to investors who plan to purchase properties to rent out to tenants – they will often raise their interest rates on that particular type of lending.

How does the cash rate affect home loans?
While the cash rate has no direct impact on home loan interest rates, and banks and lenders are not obliged to follow the decisions of the RBA, most will typically keep an eye on the cash rate and it will form part of their decision-making when setting their own interest rates. When the cash rate is low, banks and lenders may well be expected to offer lower interest rates to new homebuyers and refinancers in the housing market. A rise in the cash rate, however, could likewise mean home loan rates going up, as banks and lenders absorb and seek to pass on the cost of the rise.

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