Current Interest Rates & RBA Cash Rate

Eight times per year, the RBA holds a two-day meeting to set the cash rate, which is the interest on interbank loans, as well as loans taken from the central bank. The RBA also acts as ‘bank for the banks’ through the Exchange Settlement Account (ESA). A higher interest rate encourages banks to park their money in the ESA, instead of via chasing interest rates through lending money on the open market.

Generally, banks pass on changes to the cash rate through adjusting the rates on the loans they write, as well as the returns on products like savings or term deposit accounts.

Why is RBA cash rate so important?

Affects interest rates on banking products

If you haven’t taken out a large loan before, it’s easy to not fully appreciate the difference even seemingly small changes to your interest rates can make. Lets say you borrow $500,000 over a 30 year term. If you manage to maintain a 5% p.a interest rate the whole time, you should end up paying $466,279 in interest, with monthly repayments of $2,685. If this increased to 6%, the total interest bill becomes $579,191, and your repayments will be $2,998 each month.

If you’re confused about how this works, remember the interest rate accumulates each year based on how much you owe. Every day you owe the bank money, they will multiply the amount you owe by the interest rate, then divide that number by 365. Interest is typically charged monthly, so at the end of each month, it all gets added up.

Those who have been paying attention will realise that this means over the course of a home loan, you will gradually pay less and less interest. Your repayments will remain the same though. As you pay less and less in interest, you repay more and more of the principal. This is called an amortisation schedule.

It would be virtually unprecedented in Australia for a home loan to stay at the same rate the entire term though. While in other countries (the United States for example), mortgages can be fixed at the same rate for the whole term, fixed rates in Australia typically expire between one and five years. Variable rates fluctuate with changes to the cash rate and other things that influence a banks operations.

At Infochoice, we’re big advocates for continually shopping around, comparing your current rate with alternatives from other lenders and refinancing if you find a better deal.

Loan rates

When the RBA moves the cash rate up, the cost of borrowing money, a key operating cost for a bank, increases. They typically will pass this extra expense on to borrowers through increasing interest rates on home loans.

When the cash rate decreases, banks are likely to try and undercut one another to offer the most attractive rates, so interest rates on loans move the other way.

As you can see, home loan rates are closely correlated with the cash rate.

Savings account and term deposit rates

Savings accounts work in the opposite direction to home loans. When the cash rate is increased, banks face a higher cost of borrowing money. Therefore, they pivot to one of their other major sources of funding: consumer deposits. When the cash rate goes up, Australia often sees interest rates on savings or term deposit accounts increase accordingly, as banks look to attract depositors. When interest rates are low, banks are cutting rates to attract home loan customers, so need to simultaneously cut rates to savings accounts to balance the books.

Affects strength of Aussie Dollar

Interest rates also impact the Aussie dollar's conversion rate against foreign currency. Our Aussie dollar has a floating exchange rate, which means it is worth whatever it is deemed to be by the market (as opposed to a fixed rate where the central bank sets the exchange rate).

When interest rates are high, Australian interest yielding products are more attractive to foreign investors, who will therefore buy more. This increases the demand for the Aussie dollar, which makes it more valuable. The opposite also holds.

A weak currency does have its benefits too. When our currency is low, it makes our exports cheaper, so therefore more attractive to foreign buyers, which can boost our GDP. When our currency is relatively weak in international markets, it can benefit farming, tourism and other export industries.

For consumers though, a weak dollar means that goods purchased from overseas become comparatively more expensive. It can also push up petrol prices, since oil barrels typically trade in USD, so when the Aussie dollar is weaker, we can’t buy as much. Property prices also can spike, since foreign investors can get more for their money in Australia. The RBA needs to balance all of these concerns when adjusting the cash rate.

Why does the cash rate change?

1. Inflation

The cash rate is what the RBA call its ‘primary tool’ of monetary policy, the goal of which is to meet an agreed medium term inflation target, and maintain a strong financial system and efficient payments system. Through adjusting interest rates, the RBA aims contract or stimulate the economy by decreasing or increasing spending.

For example, when the Consumer Price Index (CPI) inflation figures are higher than target levels, the RBA is likely to want to bring prices down, so it increases the cash rate. The RBA’s target is an underlying annual rate of 2-3%.

On the other hand, the RBA could also decide that inflation isn’t high enough, and the economy needs to be stimulated by more demand. In this case, it might lower interest rates, decreasing mortgage repayments and leaving people with more money in their pocket. Savings accounts rates will also go down, so punters are less motivated to put their money away.

When demand comes down, prices typically temper, so inflation ideally returns to more manageable levels. Remember that lowering inflation rates does not exactly lower prices - that requires deflation, which can also be destructive for the economy.

2. Credit growth

An increase to the cash rate increases variable-rate mortgage repayments, meaning households have less disposable income to spend on goods and services. High rates on savings accounts also incentivises people to hold on to more of their money, which further curbs spending.

It affects businesses, too. Small businesses account for much of the business environment in Australia, and many rely on loans to fuel their operations and employ staff. When faced with higher interest rates, this can affect a business' bottom line, which in-turn takes heat out of the economy, because theoretically fewer people are employed. Employed people generally make better spenders, and inflation is simply an equation of too many dollars chasing too few goods.

3. Employment

Lower interest rates also leads businesses and banks to have more money to play with through easier lending, and less cash going towards interest payments. This then frees this up to spurn other economy-growing ventures, such as business investment, and hiring new staff. This can then boost inflation, as well as gross domestic product as the country produces more.

To generalise, high rates benefit savers and low rates benefit borrowers. The RBA needs to balance these concerns along with the outlook for employment, property and investment, all of which are influenced by the cash rate.