Reserve Bank interest rates explained
Update: December 6th 2011
The Reserve Bank of Australia has today decided to lower the cash rate by 0.25 percent, to 4.25% from 4.50%. This is a great early Christmas present for all home owners with a variable mortgage. We are now waiting on the banks to see if they will pass on the full 0.25% p.a. reduction. If you'd like to see how much you can save on your mortgage with the new interest rate cuts then request a free appointment with an Aussie Mortgage Broker today.
The main responsibility of the Reserve Bank of Australia is to formulate and implement Monetary Policy, as laid out in the Reserve Bank Act (also known as the Bank's 'charter'.) The RBA has a duty to ensure that its powers are used solely to advantage the people of Australia by positively contributing to:
- the stability of the currency of Australia;
- the maintenance of full employment in Australia; and
- the economic prosperity and welfare of the people of Australia.
The main objective of the RBA's Monetary Policy is to achieve low and stable inflation over the medium term. To accomplish this, the RBA regularly reviews Australia's interest rates.
The RBA also works to maintain financial system stability and avoid situations that could severely threaten the economic health of the country ; it promotes the safety and efficiency of the payments system and is an active participant in financial markets. Other roles include issuing Australia's currency, acting as banker for the Federal Government and managing Australia's foreign reserves.
Official interest rates are dependant upon how the economy is functioning at any given time. The RBA holds monthly meetings of the Board to determine whether the cash rate should rise, fall or remain stable. Factors considered by the RBA when making this decision include:
- the current inflation rate;
- the consumer price index (CPI);
- the producer price index (PPI); and
- levels of retail sales.
At times of stable inflation and economic slowing, the RBA might drop the official cash rate to encourage spending. However, if inflation looks set to rise above 3% in the long term, the RBA may attempt to slow things down by raising rates, regardless of the current economic state . The ultimate objective is to encourage long term growth without the severe economic ups and downs seen in past years.
Recent trends in interest rates
From the early 1990s to the end of 1998, the official cash interest rate steadily dropped from around 17.5% to 4.75%. Since December 1998, interest rates have fluctuated between 4.25% and 7.25%.
How does this affect me?
The official cash rate determines how much interest is paid to the Reserve Bank by financial institutions to use the RBA's money. When your financial institution lends this money to you for your home loan, for example, they do so at the interest rate they borrowed it at plus their margin. Lenders can determine their own home loan interest rates, raising them when the cash rate rises and dropping interest rates when the cash rate is lowered.
In 2006, Jack and Bonnie took out a variable rate home loan over 25 years. The rate their financial institution offered them was an attractive 6.32%, so for their $100,000 loan, Jack and Bonnie were repaying $664.00 a month.
By the end of 2007, interest rates had risen by half a per cent to 6.82% - still affordable for Jack and Bonnie, although repayments had now increased to $695.34 a month.
Over the following two and a half years, Jack and Bonnie continued to pay off their loan. Interest rates continued to rise slowly until, by August 2010, after yet another 0.25% rate rise, Jack and Bonnie were now paying $759.93 a month. Interest rates for their loan were now at 7.82%.
Jack and Bonnie's home loan interest rate had risen by 1.5% over the intervening four years. On their original loan of $100,000, this equated to an increase in repayments of $95.93.
If Jack and Bonnie hadn’t factored in the possibility of interest rate rises when they established their loan, they could have been in financial trouble four years later.
Don't fall into that trap of taking out a home loan that you can only just afford to pay off ; always consider the possibility that rates can rise.