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Difference between official cash rate and mortgage interest rate
142 Plays9 days ago
Think the RBA cash rate directly controls your mortgage repayments? Think again. In this eye-opening episode of Buying Your First Home, we break down how banks really decide your home loan interest rate, why they might ignore rate cuts, and how you can fight back to avoid paying thousands more. Get insider tips from Hunter Galloway on navigating rate hikes, borrowing power, and scoring the best deal on your loan.
Want to take charge of your mortgage and build wealth? Get a free home loan health check from Hunter Galloway – the home for homebuyers. Visit huntergalloway.com.au or call 1300 088 065.
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Transcript
Impact of RBA Rate Decisions on Home Buyers
00:00:00
Speaker
Banks love secrets and one of their biggest secrets is that they don't actually have to pass on the ah RBA's rate drops. Yep, you heard me right. If you buy your first home not knowing this, it could cost you thousands.
00:00:11
Speaker
Today, i're going to blow the lid off how banks actually set your home loan rate, why your payments might spike even though the cash rate's coming down and how you can beat them at their own game. Welcome to the Buying Your First Home podcast, your personal guide through the Australian housing market. Here we tackle the big questions and the small details that come up when buying your first home.
00:00:30
Speaker
From financial prep to finding the right neighbourhood, we're here to ensure that you've got all the knowledge at your fingertips. So let's take the first step towards unlocking the door to your new home.
Understanding the Cash Rate and Its Influence
00:00:45
Speaker
So what is the cash rate? Let's start with the basics. The cash rate is the interest rate for overnight loans between banks set by the Reserve Bank of Australia. In other words, it's like the wholesale price of money in our financial system.
00:00:57
Speaker
Banks sometimes need to borrow money from each other to settle all their accounts each day. And the cash rate is the interest rate they pay for these short-term loans. The Reserve Bank of Australia sets a target rate, often called the official cash rate, and by using its policy tools, it keeps the market around that target.
00:01:11
Speaker
Why does the Reserve Bank set this rate? Because it's a key part of how Australia's central bank manages the economy. The Reserve Bank board meets eight times a year to review the cash rate. If the economy is running hot and inflation is above the Reserve Bank's 2-3% target, they can increase the cash rate and make borrowing more expensive. Higher interest costs slow down spending and help bring inflation back down.
00:01:29
Speaker
On the flip side, if the economy is sluggish or unemployment is high, the Reserve Bank might cut the cash rate to encourage more lending and spending to stimulate growth. In short, raising the cash rate acts as bit of a handbrake on the economy while cutting it hits the accelerator.
00:01:43
Speaker
The cash rate has a massive influence on interest rates around Australia. It's the benchmark that banks use when they set their own interest rates for products like home loans, savings accounts, and credit cards. When you hear in the news the ah RBA change interest rates, it's really the cash rate they're talking about.
00:01:56
Speaker
Changes to the cash rate typically flow to interest rates on things like mortgages pretty quickly, often within days or weeks. But a bit of history.
Historical Perspective on Cash Rates
00:02:03
Speaker
The cash rate and interest rates generally have seen extreme highs and lows over the years.
00:02:06
Speaker
Back in the late nineteen eighty s Australia experienced very high interest rates. The cash rate peaked at over 17% in 1989. That was part of an effort to curb soaring inflation at the time. Can you imagine a 17% interest rate on a home loan today?
00:02:18
Speaker
it sounds crazy. In contrast, during the COVID-19 pandemic in 2020, the Reserve Bank slashed the cash rate to an all-time low of just 0.1% to support the economy. This meant borrowing money became historically cheap for a little while.
00:02:31
Speaker
Between those extremes, we've had plenty of ups and downs. For example, in the early 1990s, the cash rate dropped to around 5% to 6% as Australia came out of a recession. In the mid-2000s, it hovered to 5% to 7% during a growth phase.
00:02:42
Speaker
And after the GFC in 2008, the Reserve Bank cut rates sharply to soften the blow, then raise them again. I guess you can see from the examples they show the dramatic cash rate differences and how it can move depending on the economy.
00:02:52
Speaker
So the cash rate is pretty much the foundation for interest
Home Loan Rates: Variables and Fixed Options
00:02:55
Speaker
rates in Australia. It's not something you pay directly unless you're a bank borrowing money overnight, but it affects everyone indirectly. When the cash rate changes, it sets off a whole heap of chain reactions that will influence interest rates that the banks offer to you as a customer.
00:03:07
Speaker
We'll talk about that whole chain reaction in a tick. But first, let's clarify by what I mean by interest rates in the context of your home loan and how that's different from the cash rate. What is a home loan interest rate? Well, now that you know the cash rate is basically the rate banks pay to borrow money, let's talk about the interest rate you pay on your home loan.
00:03:21
Speaker
When I say interest rate in the context of your mortgage, I mean the percentage your loan amount that your lender charged you as interest, usually per year. In other words, it's the cost of borrowing money for your home. For example, if you have a $500,000 home loan with a 5% interest rate, you'd be charged around $25,000 interest over that year. Although in practice, interest is calculated daily and added to your loan balance monthly.
00:03:40
Speaker
Your interest rate effectively determines how expensive your home loan is. The higher the rate, the higher cost, the lower the rate, the lower the costs. But importantly, and the point of this video is your home loan's interest rate is not the same as the Reserve Bank of Australia's cash rate. The cash rate, like I mentioned, is the wholesale interbank rate.
00:03:55
Speaker
Your home loan rate will almost always be a few percentage points higher. But why is that? Because banks use the cash as a starting point, then they need to add their margins to cover things like cost, risk, and profit. Think of it this way. The cash rate might be the bank's own cost of funds, and the interest rate your home loan is the price they charge you, which includes a bit of a markup. For instance, if the cash rate is say 4%, the banks offer home loans at say 5.5 or 6%, that's an extra one and a half to 2% difference. This amount covers things like the bank's operating expenses, the risks that you might default, or not pay back the loan, and the profit margin for a bank's shareholders.
00:04:27
Speaker
Another key difference is that the interest rates vary from loan to loan and bank to bank. The cash rate is one single number set by the Reserve Bank Australia for the whole economy, but each lender decides the interest rate to charge for its individual customers.
00:04:38
Speaker
One bank might charge just slightly a slightly lower rate than others because they're trying to attract more customers or because their funding costs are different. Banks also tailor interest rates to situation of a borrower for the loan. For example, a loan for owner-occupied, like one that you live in, often has a lower rate than an investment property because investment loans are seen as a bit riskier.
00:04:54
Speaker
Similarly, if you have a bigger deposit or a lot of equity, meaning that you borrow a small proportion of your property's value, you get a better interest rate than someone else that's got a really small deposit. That's because your loan is a lot less risk.
00:05:05
Speaker
All these factors, the competition, funding costs and risk influence what your interest rate on your loan is. It's also worth mentioning that there are different types of interest rates on home loans. Variable interest rates, probably the most common in Australia, is a rate that can change over time. If you have a variable rate mortgage, your interest rate and your monthly repayment can either go up or down depending on what the lender adjusts your rate to be.
Strategies for Managing Loan Risk and Cost
00:05:25
Speaker
Typically, not always, variable rates move in response to the reserve bank cash rate.
00:05:29
Speaker
Fixed interest rates are less common in Australia at the moment, but this is where your interest rate is locked in for a set period, usually one, three, and five years. During that period, the interest rate will not change, even the Reserve Bank cuts rates or puts things up.
00:05:41
Speaker
You're effectively immune from rate changes to that time. After the fixed rate ends, after you say five-year period, it switches back to variable rate and you can refix that time. A split loan is the best of both worlds. Some borrowers choose a split loan where they put some variable, some fixed.
00:05:54
Speaker
This way, you've got one portion as your loan is fixed, so you know what your payments can be. Another part is variable which might go up and down depending on the market. when we talk about interest rates going up and down Australia, we could be referring to either the Reserve Bank or interest rates on home loans. And where it gets super confusing is the news might be Australian mortgage rates slashed.
00:06:10
Speaker
And they're talking about the five-year fixed rates. So don't get too caught up on that if you're not sure. Hit us up at Hunter Galloway. We're mortgage brokers and we can help review your home loan and make sure you're still on the best deal. If you've got an existing mortgage or if you're new, then we can obviously look at options for you.
00:06:24
Speaker
So to recap, your home loan interest rate is the price you pay for money from the bank. And heavily influenced by the Reserve Bank of Australia's cash rate, but also affected by other factors like each bank's costs, loan specifics.
00:06:35
Speaker
Alright, so next, let's see exactly how cash rate and home loan interest rates are connected in practice and what changes in the cash rate filter through to your mortgage. So how does the cash rate affect your mortgage repayments and your ability to borrow?
00:06:47
Speaker
Lots of Australians have experienced this firsthand recently. Imagine you took a home loan out in early 2022 with an interest rate of just 2.5%. After a year of massive rate hikes, by late 2023, your interest rate could have doubled 5.5%.
00:06:59
Speaker
On a $500,000 loan, this increase would have boosted your monthly repayments by over $700. That's the kind of real world impact the Reserve Bank's decisions can have on your household. You have to come up with an extra $700 a month.
00:07:10
Speaker
nuts. So the relationship there is pretty straightforward. When the Reserve Bank changes the cash rate, it usually leads to changes in variable home loan interest rates. If the Reserve Bank raises the cash rates, banks typically increase their variable cash rates on home loans, often by a similar amount, though not exactly the same amount. So we can get to that in second. This means that borrowers with variable rate mortgages will see their interest rates go up and consequently, your monthly repayments will also go up.
00:07:33
Speaker
On the flip side, if the Reserve Bank cuts the rates, the banks tend to lower home loan rates and borrowers can see their interest rates go down and monthly repayments go down a bit. So you get some relief. Again, let me put this into perspective. So say if you got a $500,000 home loan over 30 years, your current interest rate is 5%. At 5%, the monthly repayment on the home loan is $2,684.
00:07:51
Speaker
If the Reserve Bank hikes interest rates or increases it by 0.25% and your bank passes that on, your interest rate is going to to 5.25%. Your monthly repayment is going to increase to $2,761. That's $77 extra per month out of pocket. And you might be like, oh, that's fine. I can cover it.
00:08:07
Speaker
But over the course of a year, that's an additional $924 you need find from your budget to make your home loan repayments. and there's multiple rate hikes, it can really add up. Imagine if rates went up by 2%. On that $500,000 alone, you'd be paying an extra $615 per month.
00:08:20
Speaker
But on the flip side, if the cash rate were to drop, your interest rate was to fall from 5% to 4.75%, your monthly repayment would decrease The impact per 0.25% change roughly $15 per month every $100,000. the impact per point two five percent change is roughly fifteen dollars per month every hundred thousand dollars But how quickly does the change happen?
00:08:35
Speaker
Typically, pretty fast. The Reserve Bank announces a cash rate change usually on a Tuesday afternoon. And within days, well, recently it was within hours, the banks issue pressure releases on how they're adjusting their home loan rates. They usually say it's effective within the next fortnight or so. And then you'll see a change in your mortgage rate within a couple of weeks of that happening.
00:08:49
Speaker
Your bank will notify you either on your instant banking or by a letter with the new interest rate and when the new repayment is going to be reflected. It's important to note that the immediate effect applies to variable rate mortgages only. If you have a fixed rate mortgage, the interest rate on your loan won't change during the fixed rate period.
00:09:04
Speaker
doesn't matter what the RBA does, you're locked in. So if you fix it, say, 2% to 3% three years back in 2021, you pretty much shield it until your fixed rate expires. Once the fixed rate ends, the loan usually switches back to the current variable rate, which we reflected all the cash changes that happened since you've been fixed.
00:09:17
Speaker
So fixed rate borrowers eventually feel impact too, just with a bit of a delay.
Market Impact of High Interest Rates
00:09:21
Speaker
Beyond just your monthly repayment amount, changing interest rates can also affect how much you can borrow in the first place. When rates rise, banks have to assume higher future repayments when they're assessing your loan application, which reduces your borrowing capacity.
00:09:31
Speaker
In fact, analysts have estimated that about a 0.5% increase in rates can shrink the average person's maximum borrowing capacity by about 5%. Put it another way, if you could borrow $500,000 before, on 0.5%, half percent rate hike, you'd only borrow $475,000. Over the Reserve Bank's recent series increases, which total 4.25% 2022 to 2023, the average Australian borrowing capacity fell 40%.
00:09:46
Speaker
over the reserve bank's recent series of increases which total four point two five percent from twenty twenty two to twenty twenty three the average australian borrowing capacity fell by forty percent Which is nuts. Like I remember talking to people who before COVID or during COVID could borrow like $800,000, $900,000. They sort of went quiet for a couple of years, came back to me. And after all these rate hikes, they could only borrow $480,000 to $500,000. It was pretty savage.
00:10:09
Speaker
Equally on the other side of the coin, when rates start to drop, borrowing capacity increases again, making easier qualify for larger loans. For existing homeowners, higher interest rates obviously mean you need to allocate more income to your mortgage repayments.
00:10:20
Speaker
This can squeeze your budget, which means you have to cut back on other expenses to cover the larger mortgage repayments. If you're first home buyer, higher interest rates can be a bit of a double-edged sword. and You might not be able to borrow as much and higher payments can be daunting.
00:10:31
Speaker
At the same time, higher interest rates can cool down hotter property prices. When borrowing is more expensive, fewer people can afford to take out big loans, which slows down demand for homes. Historically, we've seen some cases where house prices can stagnate or dip with higher interest rates, which could make it more affordable for you as a first home buyer. There's also a bit of a silver lining if you're still trying to save a deposit.
00:10:50
Speaker
If there are higher interest rates, have to get higher savings accounts. But as interest rates come down, your savings accounts are going to get slashed as well. So to sum up, the Reserve Bank cash rate and your home loan interest rate are pretty tightly linked. When the cash rate changes, your variable home loan or even your savings account actually changes as well pretty shortly thereafter.
00:11:06
Speaker
Specifically with the home it's going to affect your mortgage repayments. High cash rate equals higher home loan rates equals higher repayments and lower borrowing capacity. A lower cash rate equals lower home loan rates, lower payments and also higher borrowing capacity. So it probably makes sense why the next Reserve Bank cash rate announcement can affect you in the future.
00:11:22
Speaker
Which brings me to my next question. If the Reserve Bank's cash rate and home loan rates are so connected, why is it sometimes that the banks don't pass on the full rate cut or hike? In other words, why is it that banks don't always mirror the RBA's moves?
00:11:33
Speaker
Let's go through that. If the cash rate and home loan rates are so closely linked, you might wonder why sometimes the banks don't exactly follow the RBA's moves. For instance, you might have seen the news, the Reserve Bank's cut the cash rate. Most of the banks are passing on the rate cut.
00:11:45
Speaker
in the full 0.25%, but there are some that are passing on none at all. There's some only passing on 0.15, like partially, and you might be wondering what's going on here. The key thing to remember is that while the Reserve Bank's cash rate heavily influences the bank's interest rate costs, banks can ultimately set their own rates based on a variety of factors.
00:12:02
Speaker
They're not legally required to match Reserve Bank's cash rate one-for-one, though there's often a lot of public and political pressure to do so. Essentially, it's up to them when it comes to the cuts or hikes. Here's some of the big reasons why banks don't always move in lockstep with the ah RBA.
00:12:15
Speaker
Firstly, funding costs. Banks get the money they lend out from multiple sources. One source is the RBA overnight market, influenced by the cash rate. They also raise funds from customer deposits and from overseas and domestic money markets.
00:12:25
Speaker
If the cost of these other sources doesn't fall in line with the cash rate, banks might not pass on the cash rate in full. A great example is deposit rates. Banks take deposits from customers and then pay interest on these. When the cash rate is very low, deposit rates were also really near low, near zero in a lot of cases. Banks were reluctant to cut deposit rates below a certain level because they didn't want to drive savers away. So as the cash rate approached near zero, banks didn't always cut the full amount of the home loan interest rates because they needed to keep their overall funding costs in check.
00:12:51
Speaker
For example, in June 2019, the ah RBA cut the cash rate by 0.25%. Two of the big four banks, ANZ and Westpac, passed on only 0.15% and 0.2% of the rate cut to their mortgage customers, while the other two big banks, CBA and NAB, passed on the 0.25%.
00:13:05
Speaker
This partial pass-through made massive headlines the time. It was an instance of banks prioritizing their margins under pressure for funding costs. Profit and shareholders. This ties in with the funding costs. Banks are businesses and they aim to make a profit.
00:13:16
Speaker
If giving the full benefit of the cash cut could squeeze their profit margins, they might decide to keep that for themselves. Like I mentioned, in 2019 it happened and it can be pretty frustrating for borrowers. The Reserve Bank was trying to make loans cheaper and yeah stimulate the economy and the banks would pretty much skim it for themselves, their profit.
00:13:30
Speaker
From the bank's point of view, they have to balance keeping customers happy with keeping their shareholders and depositors happy as well, and while meeting all regulatory requirements. We'll see the Australian competition Watchtog found that profitability was a major factor in the bank's decision not to fully pass on rate cuts in 2019.
00:13:46
Speaker
In other words, the banks consciously withheld part of the ah RBA's cuts to shore up their profitability when their own costs like deposit interest rates hit a floor. The next one is competition. Competition can work in two ways.
00:13:56
Speaker
If a bank doesn't pass on a cut, customers might just jump the shift and find another bank that does. Knowing this sometimes means a bank will pass on all if not most of the cut
Bank Responses to RBA Rate Changes
00:14:06
Speaker
to avoid losing business.
00:14:07
Speaker
On the other hand, if all major banks are in the same boat with rising funding costs and margin pressure, they might all just decide to hold back similarly. Since they know their customers are going to have real no other options, but in reality, we often see all big four banks moving pretty similarly on rates.
00:14:22
Speaker
small banks online banks often buck the trend though. For instance, they might cut rates more aggressively or delay cuts to attract more customers. We saw Unloan do that a lot where the interest rates might have gone up, all the other banks had passed things on and they just delayed a little bit longer to make their rate look like it was much more attractive and then put the rate cuts up by more and even actually did more. There were some where the Reserve Bank increased rates by 0.25% and Unloan did it by 0.3%.
00:14:45
Speaker
But depending on competitive pressures, a bank might diverge from the RBA either to protect its market share or profit margin. Another reason is different loan products. Not all interest rates move the same. The RBA's cash rate influences variable rates, but fixed rates influenced by more longer term factors like the bond markets and international markets.
00:15:00
Speaker
Sometimes banks will adjust fixed rate mortgages independently of rba because it depends on the futures markets. They can be all over the shop. So for this reason, historically, fixed rates have been a lot less competitive and compelling for people in Australia. It's not like in America where you get a 30-year fixed rate term. So you'll just have to see what the fixed rates are on the day that you're potentially getting your mortgage or what your situation is to see if they make sense.
00:15:20
Speaker
Another factor is global financial conditions. Sometimes banks adjust rates even when the RBA hasn't changed rates at all. These are often called out-of-cycle rate changes. One common reason is changing costs of borrowing from global markets.
00:15:31
Speaker
As I mentioned earlier, Australian banks borrow a portion of their funds from overseas. If overseas interest rates go up or if global credit markets tighten, for instance, we saw it during the global financial crisis, the banks might find their cost of money has risen even if the ah RBA has left the cash rate unchanged. Rather than resolve that cost, they might raise the mortgage rates to compensate.
00:15:48
Speaker
In 2018, we saw several lenders raise their interest rates by 0.1 to 0.15% out of cycle, citing higher funding costs at a time when the Reserve Bank cash rate had been stable. These moves aren't that common, but they do happen. And they illustrate that the Reserve Bank's cash rate isn't the only factor determining your home loan interest rate.
00:16:04
Speaker
Timing and other considerations. Even when the banks do follow the RBA's direction, they might differ in terms of timing or exact amount. One bank might announce the changes to happen right now today on the same day. Another might wait a week or two. Also, some banks might pass on, say, a 0.2% immediately and a 0.05% later in the month. This is less common, but we might see it even sometimes. you know A 0.25% rate reduction will apply on existing customers and new-to-bank customers only get a 0.2%.
00:16:29
Speaker
two percent So we do see differences there. It is interesting to see that a rate increase is usually mirrored by the bank or increased almost immediately. They want to get on that because every day is costing them millions of dollars.
00:16:40
Speaker
And a rate drop is usually delayed or partially passed on weeks later.
Advice for Navigating Mortgage Options
00:16:44
Speaker
But to sum up, banks don't always follow the Reserve Bank to the letter because they have to juggle their own profits, their goals and competitive positioning.
00:16:50
Speaker
The Reserve Bank's cash rate sets the overall tone, but think of it as setting a playing field. But if you was a borrower, it means really two things. Don't automatically assume that the RBA cut will reduce your home loan rate by the same amount.
00:17:01
Speaker
So keep an eye out on what actual bank does. And different lenders might respond differently. So can pay to shop around or speak to your mortgage broker depending on how the RBA moves with your loan. So what does it mean for you as a home buyer? Well, a couple of things. You want to be across Reserve Bank decisions because ultimately, any changes in the cash rate are going to affect your home loan repayments, your budgeting, and your way of living really. So keep across on that. You want to have a mortgage broker that's actively negotiating and chopping around your mortgage.
00:17:25
Speaker
At Hunts Gallery, we do annual reviews for all our customers, sometimes more frequently depending on the rate movements. So keep an eye on that because your rate is competitive today or your bank is competitive today. It doesn't mean they're going to be like that forever. And use things like offset accounts and redraw every extra payment you make, every extra dollar that's in your offset account is helping you pay off that loan quicker and helping you get ahead of your home loan.
00:17:45
Speaker
so there's a lot to go through. Understanding the interest rates and how it impacts you can make all the world a difference in your financial future. At Hunter Galloway, we're the home for homeowners and home buyers across Australia. If you've got a mortgage, we'd love to help you out. If you're thinking about getting the market, hit us up at huntergalloway.com.au. If you found any value from this video, give us a thumbs up. Hope you liked it. Try a bit of a new format, a bit longer.
00:18:05
Speaker
got any questions, hit me up in the comment below. We'd love to hear from you. Thanks so much for watching. Appreciate it and see you next time.