In Australia, the official cash rate and the interest rates on loans and bank accounts are two different things. The official cash rate, determined by our central banking system, significantly impacts the interest rates financial institutions assign to their product offerings. We will explore these two distinct rates, laying down their differences and identifying how they are related. This insight can steer you toward wise decisions when picking a loan or a bank account. So, let’s jump right in!
Understanding the Cash Rate
The monetary rate at which commercial banks obtain loans from a country’s central bank is the cash rate, base rate, or official interest rate. The Reserve Bank of Australia (RBA) sets the cash rate. It’s essential to note that the RBA uses this cash rate as a key instrument in its monetary policy toolbox, primarily aiming to control inflation and ensure the nation’s economic stability.
The RBA may lower the cash rate if the economy struggles to stimulate spending and investment. If the economy is overheating, it may raise the cash rate to curb inflation. The cash rate impacts everything from customer interest to goods and services prices. Here are five key points about the cash rate:
- Economic Boost: The RBA might slash the cash rate when the economy grapples with sluggish growth or high joblessness. This step makes borrowing less costly, spurring spending. For instance, a fall in the cash rate from 1.5% to 1% could translate into an annual saving of about $2,500 on a $500,000 home loan’s interest payment. Such savings could increase economic activity as people have more expendable income.
- Inflation Management: If the economy is thriving and there’s a danger of inflation escalating too rapidly, the RBA might hike the cash rate. This move can help temper the economy by making borrowing pricier.
- Commercial Bank Interest Rates: The cash rate directly impacts the interest rates that commercial banks offer their clients. Banks typically modify their lending rates when the RBA alters the cash rate. If the RBA boosts the cash rate, your bank will likely raise its mortgage interest rate, and the opposite is also true.
- Savings and Deposits: The cash rate directly influences the interest rates provided by banks for savings and deposits. When the cash rate increases, savers may enjoy improved returns as banks raise their interest rates on savings accounts and term deposits in alignment with the RBA. Conversely, the interest earned on savings and deposits might also decrease when the cash rate is low.
- Housing Market Impact: The cash rate significantly affects the housing market. When the cash rate is low, borrowing becomes cheaper; this can increase home loan applications, causing a potential rise in property prices due to increased demand. On the other hand, a high cash rate, resulting in more expensive loans, can cool off the housing market as borrowing to buy property becomes costlier.
Cash Rate vs Interest Rate
At first, these two may appear alike, but they perform unique functions in finance and have varying effects on your home loan expenses.
- Function in the Financial Sphere: The cash rate is a macroeconomic instrument the central bank uses to control the economy, manage inflation, and regulate economic growth. On the other hand, the interest rate is a borrowing expense set by individual lenders, influenced by factors like the cash rate, the lender’s funding costs, and the loan’s associated risk level.
- Rate Determination: The RBA determines the cash rate. However, individual banks and lending establishments determine their own interest rates. Although the cash rate influences it, other factors like the lender’s business strategy and market competition also play a role.
- Influence on Home Loan Expenses: Cash rate changes can directly or indirectly impact home loan interest rates. When the RBA slashes the cash rate, it diminishes the bank’s expense to access funds. Lenders often respond by lowering their interest rates, making home loans more financially accessible for borrowers. Conversely, an increase in the cash rate means higher bank borrowing costs. To counterbalance this expenditure, lenders often elevate their interest rates, which can lead to pricier home loans for borrowers.
- Borrower Impact: Comprehending the differences between cash and interest rates is crucial for borrowers. It can assist you in predicting potential shifts in your home loan expenses. For example, if the cash rate is predicted to increase, you can secure your interest rate with a fixed-rate home loan.
How Cash and Interest Rates Affect Your Home Loan
Understanding their functions is essential for prospective homebuyers and homeowners alike. Here’s how they can affect your home loan:
- Impact on Fixed vs Variable Rate Loans: Your susceptibility to cash and interest rate changes depends on the type of home loan you choose. When you choose a fixed-rate loan, your interest rate stays the same for a set duration, irrespective of any cash rate fluctuations. Conversely, a variable-rate loan can adjust according to the cash rate, resulting in potential changes to your repayments—either higher or lower.
- Influence on Decisions about Refinancing: Changes in the cash rate could impact your considerations for refinancing your home loan. If there is a reduction in the cash rate, lenders may be more disposed to provide lower interest rates, making refinancing more enticing.
- Effect of Loan Rates: The interest rate connected to your home loan directly affects the amount of your mortgage repayments. Even a minor adjustment in the interest rate can substantially affect both your monthly payments and the overall amount repaid throughout the loan’s duration.
- Cash Rate Fluctuations: The cash rate can experience regular changes based on the country’s economic condition. If the central bank were to reduce the cash rate by 0.25%, and your lender passes on the entire cut, the interest rate on your $500,000 home loan might be reduced from 3.5% to 3.25%.
- Strategic Planning for Future Rate Changes: Staying informed about economic forecasts and potential cash rate changes can help you plan strategically for the future. If there are indications that the cash rate may rise soon, you should consider locking in a current low rate with a fixed-rate home loan.
Strategies for Navigating Changing Rates
Understanding how cash and interest rates work is only half the battle. Having strategies to handle fluctuating rates is crucial. Consider these recommendations:
- Stay Informed About RBA Announcements: The RBA convenes every first Tuesday of each month to assess economic conditions and determine cash rate adjustments. Keeping track of these updates can help you stay ahead and make informed decisions. Staying well-informed about these announcements allows you to foresee possible changes in your home loan interest rate and make suitable preparations.
- Explore Various Home Loan Options: Numerous types of home loans exist, each with pros and cons. Fixed-rate loans provide stability by maintaining the same interest rate for a specific period, irrespective of market fluctuations. On the other hand, variable-rate loans offer potential savings if rates decrease but can also increase if rates rise. Split loans, partly fixed and variable, offer a balance of security and potential savings. Know more about the difference between these three home loan types here.
- Consider making extra repayments: If your financial situation allows, adding extra repayments can lead to significant interest reduction over the loan’s duration. This strategy can accelerate your loan repayment and result in long-term savings.
- Seek Professional Guidance: Consulting a financial advisor or mortgage broker can offer personalised insights based on your circumstances. They can assist you in navigating rate changes and making well-informed decisions about your home loan.
- Regularly Review Your Loan: Regularly monitor your home loan to ensure it aligns with your requirements, especially during interest rate fluctuations. If you discover a more advantageous loan option, contemplating refinancing could be beneficial.
- Have a Buffer: Interest rates can increase, leading to higher repayment amounts. To prepare for this possibility, having a financial buffer is wise. This way, you can manage increased repayments without straining your budget.
- Understand Prepayment Penalties: Some home loans include penalties for early repayment. Be sure to understand these penalties to avoid unexpected costs if you plan to make extra repayments or pay off your loan early.
- Utilise an Offset Account: One effective strategy is to utilise an offset account. This type of account is linked to your home loan, and the account balance is deducted from, or ‘offset’ against, the balance of your loan when calculating interest charges. This can result in significant interest savings over time. Find out more about what an offset account is here.
- Stay Updated on Financial News: Lastly, staying informed about the broader economic landscape can help you make strategic decisions about your home loan. Regularly reading financial news, subscribing to relevant newsletters, and participating in webinars can keep you updated on trends and forecasts related to interest rates. Here at Lendstreet, we regularly provide market updates, insights, relevant home loan tips, and advice through our articles. You can check our entire library here.