Understanding interest rates

Understanding interest rates

The Reserve Bank of Australia has just released its latest decision on the nation’s cash rate, which in turn influences interest rates. This time, the bank has decided to keep the rate on hold - but it’s always a big news story, no matter which way it goes, with journalists racing to publish the decision and economists called on to analyse the impact. It’s also a topic which can be hard to get your head around, so in this Squiz Shortcut, we’ll explain:

• Some of the jargon used when interest rates are discussed

• How they work

• And the impact they have on our lives…

🙋🏻‍♀️ This newsletter was written by Andrew Williams

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Squiz the Shortcut

Let’s start with the basics… What’s an interest rate?
Think of it as the price of borrowing money. If you lend money to someone else, or someone lends money to you, the interest rate is the cost of borrowing that money. So if you borrow $100 from a friend at an interest rate of 5% per year and pay it back a year later, you’ll hand over $105 - so it’s cost you $5 to borrow that $100… 

Got it… So why do people pay so much attention to them?
Well, when you do those calculations on a home loan (which tend to be way more than $100…), the numbers get big, fast. So people watch interest rates closely because they can go up or down which affects how much money they have to pay back to their bank/lender.

What are the most common ways people encounter interest rates?
Via their home loan, or a credit card, or savings accounts. One of the most important things to know is that we use the term ‘interest rates’ for a reason. There’s no single rate, and they vary in terms of cost and how they’re structured…

Who controls how they’re set?
That’s one of the roles of our central bank, the Reserve Bank of Australia (RBA). If you want to know a bit more about how it works, we’ve published a Squiz Shortcut on it that we’ll link to at the end. Basically, the RBA controls our national cash rate - aka the cost of our money. 

Why is it called the cash rate?
It’s derived from something called the cash market. Every transaction on a given day - paying a bill, or transferring money to a mate - involves moving money between Australia’s various financial institutions…

How does that work?
On a given day, that can total $200 billion - so to settle all of that, banks hold money with the RBA (in reserve, you might say), and settle those various transactions overnight. That’s called the cash market, and the interest rate they charge each other on the money they borrow is the cash rate. 

So, if the banks are the only ones charging it, why is the cash rate reported so widely?
It’s because it influences the interest rates we see from banks… It shapes what the banks charge each other, which plays into how much they charge as their retail rate to borrowers, and how much money they make.

What happens when the cash rate moves?
If it goes up, the interest rates banks charge on the money they lend people generally goes up as well. If the cash rate goes down, it generally goes down - though, not always… 

Why does the RBA make a decision about the cash rate every couple of months?
It has 2 big jobs - to keep prices stable and to keep employment high. You might’ve heard the bank’s Governor Michele Bullock say many times that the board wants inflation - the rate at which things get more expensive - to stay between 2-3%. At the moment, it’s above that. 

And how do higher interest rates help with that?
By making interest rates higher, the RBA is using a lever it has to try to slow it down - because it means saving money becomes more attractive, and people are less likely to spend money, which is what drives inflation. But push them too high and spending stops, the economy stops growing and people start losing their jobs…

So it’s a tricky balance?
Very much… It’s like turning down the heat on a saucepan so it doesn’t simmer over - but you also still want the food to cook. So, when the RBA raises the interest rate by 25 basis points, as it has done 3 times this year, it’s tipping the balance more towards cooling inflation…

Righto, what’s a basis point…?
It’s a term you might hear a lot when the RBA makes decisions on the cash rate - if it goes from 4 to 4.25%, people say that it goes up ‘25 basis points’. A basis point is one one-hundredth of a percent - so 100 basis points equals 1 percentage point. 

So why not just say it went up 0.25%?
Because that can be read 2 ways… You could be saying that it went up 0.25% of the original rate - which from 4% would be a tiny, tiny change - but by saying that it went up 25 basis points, you’re keeping it clear that it’s gone from 4 to 4.25%…

Let’s get to the pointy end… What does it mean for people with a mortgage?
Everyone’s home loan is different, but we’ll use an example of a $600,000 mortgage in Australia over a term of 25 years. A 25 basis point move either way will mean that an average mortgage holder - if they’re on a variable rate - would pay $91 a month more or less on their repayments. That’s the impact of the cash rate decision in ‘real’ money. 

And 3 moves in a year…?
Like we’ve had this year means your average mortgage holder will pay about $275 a month more - which is where the cost of living starts to bite.

And how are renters affected?
Because many landlords are paying off mortgages, if their repayments go up, renters cop it too in the form of rent rises. 

Are interest rates on home loans the only ones that move?
No - but they’re usually the fastest… The cash rate decision also influences a bunch of other interest rates too. One of those is the interest paid on savings. The cash rate rising might be bad news for mortgage holders, but it’s good news for savers - if you have money in the bank earning interest, the higher the interest rate, the more you’re earning on it.

So it’s good news for retirees…
Exactly… If, for example, they’re living off income from savings they’ve accumulated over time - but that good news can be a bit slower to arrive. As a general rule, the banks tend to move the mortgage rate before they move on saver rates… And then there’s the rate that barely moves at all - credit… 

Tell me more about that…
Aussies owe well over 40 billion on their credit cards, with over half of that accruing interest. But this is where the influence of the cash rate wanes a bit - the cash rate has moved 3 times this year, but credit card interest rates really haven’t changed very much… 

Why is that?
It’s largely because credit card interest tends to be much much higher than mortgage interest rates - they can be more in the realm of 20%, compared to say 6-7%. In other words, credit card rates are already so high that a small cash rate change doesn't make much difference to what’s owed. 

So mortgages get the headlines?
Yep, because that’s where the most impact is felt by the most people. It’s no doubt where most of the coverage will continue to land, but it’s not the only thing that’s impacted by the RBA’s cash rate decisions.

Onto our Recommendations

Reading: The RBA’s own explanation of the cash rate and what it’s trying to achieve…

Reading: This article, put out by the ABC the last time the RBA raised rates in May, gives some helpful context for the decision…

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