While we understand banks charge interest on their home loans, exactly what determines the rate? Should we be worried that interest rates will spike higher in the years ahead?
For most people, it’s all a bit of a puzzle.
Traditionally, the Reserve Bank of Australia (RBA) is tasked with the responsibility of setting interest rates. It does this at monthly board meetings by determining the so-called cash rate, or the price the big retail banks pay to borrow money in the overnight cash markets.
This is part of a complex mechanism the Reserve Bank uses to control the level of cash or liquidity in the banking system. Doing so directly impacts the rate of interest charged by banks, not just on home loans but also on every product they sell.
This is a critical lever the Reserve Bank uses to regulate economic activity.
For example, suppose the economy is slowing. In that case, the RBA can lower the cash rate, increase liquidity throughout the banking system and, encourage the big banks to reduce rates.
If the economy is trading too strongly, as indicated by a sharp upturn in property prices or a jump in the inflation rate. The RBA can use the cash rate to reduce liquidity, increase interest rates, and slow activity.
The RBA announces the decision to change the cash rate following its monthly board meetings.
Regulating the economy is as much an art as it is a science. With market analysts studying the RBA’s monthly board meeting minutes to gain a sense of the bank’s attitude toward interest rates.
In the minutes following the April 2022 cash rate hike, the RBA said it considered raising the cash rate between 0.15 per cent and by 0.4 per cent. However, it is decided on that a 0.25 per is the increase.
To emphasise this point, the Reserve Bank boss of the time, Phil Lowe, noted it ‘was not unreasonable to expect’ the cash rate to climb as high as 2.5 per cent in the near future.
This statement sent a shudder through the money markets. Suddenly, the media was full of stories. It Speculates that interest rates could rise higher as part of the RBA’s determination to lower inflation and cool local economic activity.
However, just the talk of higher interest rates can achieve the desired impact on economic activity. Itself can reduce the need for rate increases and, with that, lower how high rates need to rise.
The situation is complex.
There are many Australians who live on credit. They have taken out substantial home loans believing record low interest rates would remain for years. Therefore, even a small rate hike can significantly impact the cost of their mortgage.
The COVID-19 pandemic encouraged Australians to save. Market Economics contributed estimating an extra $50 billion to home loans during this time. On average, home buyers were then 45 months ahead on their repayments.
The tough competition among Australia’s big banks can put significant downward pressure on all rates, including home loans. Innovation and technology reduces lending cost.
For example, the Commonwealth Bank of Australia released a new digital home loan, Unloan. The bank sets the interest rate significantly below its current lowest variable rate home loan. The bank will also reduce by one basis point for every year the loan is held the prevailing rate of interest charged on this loan.
Such factors make the RBA’s task of moderating economic activity through cash rate adjustments even more challenging. However, understanding a little about the mechanisms behind each cash rate adjustment can ease uncertainty about future interest rate fluctuations. This help us all feel more comfortable in our own financial positions.
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