Why are bank interest rates different to the cash rate? | Compare Money

Home Economy Why are bank interest rates different to the cash rate? | Compare Money
Why are bank interest rates different to the cash rate? | Compare Money

When the Reserve Bank sets the official cash rate, some banks pass on the rate cuts or increases, while others don’t. The RBA cash rate can influence every form of credit from mortgages to credit cards and payday loans. So why aren’t they all the same? Could they be? Find out why mortgage interest rates are always higher than the official cash rate and how the system works in practice.

What is the cash rate?

In Australia and most western countries, a central bank issues what’s known as the cash rate, which is a percentage per annum (per year).

In Australia that central bank is known as the Reserve Bank of Australia (RBA), and every month (except January) the board of the RBA sits to determine the official cash rate.

The official cash rate is also known as the “overnight money market interest rate.” This is the interest rate that commercial banks borrow at and an important factor in determining how interest rates are set.

The cash rate can also influence how much you get paid on savings deposits by banks.

How is the cash rate controlled?

A central bank or a reserve bank has powers to set the monetary policy of a given country, which in Australia is the Reserve Bank of Australia.

The Reserve Bank of Australia says, “Its duty is to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people. It does this by conducting monetary policy to meet an agreed medium-term inflation target, working to maintain a strong financial system and efficient payments system, and issuing the nation’s banknotes.”

The Reserve Bank uses a medium term inflation target to help maintain price stability, full employment, and prosperity and welfare of the Australian people. Higher inflation can result in the prices of goods and services households buy increasing, which means the purchasing power of your money is weaker than before.

In an attempt to help maintain their medium term inflation target, the RBA implements their monetary policy. The primary tool at the RBA’s disposal is the cash rate, which they review and set at their monthly board meeting.

How is the cash rate related to the interest rate?

In most cases, the higher the cash rate, the higher the interest rate. This is because it costs lenders more to borrow money they lend to their borrowers.

In 2022 we have seen a sharp increase in inflation and consequently, the RBA increased the official cash rate seven times between May and November 2022, taking it from a record low 0.1 per cent to 2.85 per cent.

That means a sharp increase in the cost for lenders to borrow money, and when we’re talking about billions of dollars, it is significant.

Commercial banks and lenders are generally in the business of making a profit. So, a simplistic view is that the interest rate they charge for loans must be greater than the cost at which they borrowed the money – which is impacted by the cash rate.

What affects interest rates?

Many factors other than the cash rate affect interest rates. Banks and lenders don’t just use a single source for their loans. They can also look to bigger lenders here and overseas.

If the Australian dollar is weaker against other currencies such as the US dollar or British pound sterling, borrowing costs can increase as more Australian dollars are needed to buy foreign currency.

Risk is also a factor in setting interest rates. In a weaker economy where unemployment is high or house prices are unusually high, banks may set higher rates to help spread the risk out over many borrowers. The higher the risk, the higher the interest rate.

“Bad credit” customers often have the highest interest of all due to their higher risk factor. Short-term loans are also riskier and have smaller margins, which is why they will generally have much higher rates.

While banks and lenders will look to ensure they are turning a profit for their shareholders, they also need to remain competitive. Lenders need to keep their interest rates attractive and competitive to would-be borrowers, so they need to find a balance.

So, as you can see, the cash rate is not the only factor the banks need to consider when they set the actual interest rate that they charge on their various loan products.

Do banks have to pass on the full rate rises?

No, banks and lenders don’t have to pass on cash rate changes, but they do try to be mindful of the behaviour of their competitors. If borrowers have the chance to snap up a better deal elsewhere – they will!

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