Home owners often wait with bated breath for RBA cash rate announcements—celebrating when rates drop and sighing when they rise. But why is this?
Let’s explore how the cash rate controls the flow of money though the economy, broadly guides inflation, and directly impacts the disposable income of millions of Australians.
What is the cash rate?
Often referred to by economists as a ‘blunt instrument’, the cash rate is a tool used by the Reserve Bank of Australia (RBA) to control the amount of spending in the economy, and in-turn influence inflation. Sounds confusing?
When there’s more money in the economy, prices often increase as people have more money left over each month to spend on goods and services. This leads to higher inflation (an increase in the cost of everyday goods and services).
When we have less money left over each month, we tend to limit our spending on non-essential items. This keeps retailers in-check to limit price rises and often compete harder for our hard-earned cash. This helps limit inflation.
How the cash rate can impact the cost of your mortgage
This cash rate determines the cost of funds for banks and businesses to lend to one another. There are many factors at play here, but at a basic level, when the cash rate increases, the amount of interest a bank or lender charges will increase. When the cash rate decreases, the amount of interest charged decreases.
When the cash rate decreases, if passed on by your lender, the interest charged on your mortgage will decrease, giving you more money left over each month!
When the cash rate increases, if passed on by your lender, interest charged on your mortgage will increase, meaning you’ll have less money left over each month.
What if I’m on a fixed rate? If you’re on a fixed rate mortgage, then the interest charged won’t change for the duration of your fixed loan term. This could be good if rates are rising, however, you may be stuck paying more if you are on a fixed rate loan and rates suddenly start dropping. It’s a key consideration to discuss with your broker or financial planner.
Tip: If your lender decreases the interest charged on your loan, you could consider keeping your repayments the same. Even though you might be charged less interest each month, keeping repayments the same will help you pay down your principal faster.
How the cash rate could impact your borrowing capacity
Cash rate changes don’t just impact existing mortgage holders. A change in the cash rate will impact how much new applicants can borrow, due to a change in their serviceability.
Serviceability, or a serviceability assessment, is when a lender determines the size of a loan you could comfortably repay based on your current net income (that’s your income minus expenses).
Here’s a quick example:
Let’s say you could afford to spend roughly $2,300 per month on loan repayments.
When the interest rate is at 4%, you would be able to borrow roughly $500,000. However, if the interest rate were to go up to say 7%, then the same repayments would only be able to service a smaller loan of $340,000. This is because a larger proportion of your $2,300 each month will go directly to interest.
Will a lower cash rate fuel house price growth?
Although this is also impacted by broader economic conditions, rate drops can often increase housing prices.
When your borrowing capacity increases following a rate drop, you need to remember that the rate drop also applies to others in the housing market – meaning an increase in borrowing capacity across the board. Since more people can now afford to borrow more, those same people would be willing to offer more to purchase the same property.
Your cash rate cheat sheet
Lower cash rate = less interest charged, more disposable income. Can potentially fuel inflation and property price rises.
Higher cash rate = more interest charged, less disposable income. Helps put a break on inflation and stop property prices rising so quickly.
Terms and conditions and lending criteria apply. All applications are subject to assessment.
The information provided in this article is general in nature and is not intended to be financial advice. We always recommend you seek your own, independent financial advice which can take into consideration your specific circumstances.
