If you are in the market for a home loan, you might have heard a lot of discussion about the official cash rate and how it affects your mortgage interest rate. You might even wonder whether the official cash rate is the same as your mortgage interest rate because the two seem intrinsically connected. However, that’s not entirely true. The official cash rate and your mortgage interest rate are two different things, even though the mortgage interest rate is likely to follow the cash rate.
What is the official cash rate?
The official cash rate, set by the Reserve Bank of Australia, is the interest rate that lenders must pay on the money they borrow from each other. The official interest rate is also called the overnight money market interest rate because money transfers between banks generally happen overnight. The cash rate determines the interest payable on this money.
The RBA meets on the first Tuesday of every month, except in January, to discuss the official cash rate. Depending on various economic factors, it may decide to keep the rate on hold or choose to increase or decrease it.
In May this year, the RBA announced an interest rate hike for the first time since November 2010. It has been noted that the interest rate hike is in response to the increasing inflation levels, and more hikes are expected to bring inflation under control.
In general, cash rate movements are determined by economic factors like inflation, employment and wage growth. When the cash rate is low, it is expected to stimulate household spending and investing as borrowing money becomes cheaper, creating more jobs and wage growth. On the other hand, a higher cash rate typically encourages people to save, leading to less money in circulation, which could help reduce inflation levels.
How is the official cash rate related to your mortgage interest rate?
The official cash rate determines what it costs the banks and lenders to borrow money. When the cash rate increases, borrowing becomes costly for lenders, and they are likely to pass on the hike to their customers to maintain their profits. Similarly, when the official cash rate is reduced, borrowing becomes cheaper for lenders, and they might pass on the cut to their customers to remain competitive. It means variable mortgage interest rates should rise when the official cash rate increases, and reduce each time there are cash rate cuts.
It’s worth knowing that even though lenders should mirror the cash rate changes, they don’t always pass on a cash rate in full or to all their customers equally. For instance, a lender may only offer a reduced interest rate to new customers but continue charging the same rate to its existing customers. Similarly, banks and lenders don’t necessarily have to pass on the entire rate hike to their customers.
What can you do to protect yourself from future rate hikes?
The RBA is expected to further increase the official cash rate and mortgage interest rates are likely to rise. Besides saving money and budgeting for increased monthly repayments, there are some other things you can do to prepare for the rate hikes.
One of the options you have is renegotiating the interest rate on your home loan or refinancing if you find a better rate elsewhere.
The interest rate that a bank or lender charges you depends on various factors other than the official cash rate. Lenders generally reserve their best rates for low risk borrowers who are considered less likely to default on their mortgage repayments. Having stable income and employment and a high credit score can put you in this preferred category of borrowers, giving you more room to negotiate a better rate on your home loan.
Some borrowers might also consider fixing their home loan to temporarily protect themselves from interest rate hikes. However, this option has its pros and cons, and it could help to speak with an expert to determine the right type of home loan for you.
While a variable interest rate allows you to benefit from the lows in the market, you also face the uncertainty of sudden rate hikes. On the other hand, a fixed rate home loan gives you the peace of mind that your interest rate will not change for a specified time. However, the fixed rates offered by lenders are currently higher than their variable rates in most cases. Fixed rate home loans are also considered less flexible than variable rate home loans, and you might be charged a fee for exiting or paying the loan early. There’s a third option – a split rate – that allows you to pay a variable interest rate on a part of your mortgage and a fixed rate on the remaining portion. A mortgage broker can help you understand the difference between different interest types and how they can affect your repayments to help you make an informed choice.
