Interest Rates Explained
In recent times, you probably hear it all over the news and read it in the papers (or online): “The Reserve Bank of Australia keeps interest rates at a record-low” – but what does this actually all mean? What impact does this have on you as a borrower, lender or investor?
Before diving into the key question at hand, it’s important to first understand what role interest rates within the Australian economy – both on a microeconomic and macroeconomic level.
What is an interest rate?
At its core, an interest rate is the cost of borrowing money incurred by the borrower. On the other hand, it is the benefit received by the party lending money for providing the service and assuming a level of risk to provide the loan.
Interest rates have a major impact on a country’s economy as it promotes the movement of available funds between entities in surplus of funds and entities in deficit who require these funds. This cycle of borrowing, lending, and spending continues, thus, stimulating the economy.
Interest rates change constantly, and different types of loans and investments offer various rates of interest. It is important to understand the factors for these changes and differences, regardless of whether you are a lender, borrower, or investor.
What Causes Interest Rates To Change?
Inflation is the quantitative measurement of the rate at which the average price of selected goods and services increase (or decrease) over a period of time. It is a primary economic metric which the constituents of a country are able to benchmark the purchasing power of their money – as inflation rises, the average cost of goods increases.
The inflation rate is expressed as a percentage and will vary by economy, with the highest reported inflation rates (as of the date of this article) being 2431% in Venezuela and the lowest of in Eritrea (-27.6%). Australia has a reported interest rate of 2.2%, which is within the RBA’s inflation target of “2-3%, on average, over time”.
As such, as inflation levels increase, interest rates also increase as lenders will want a higher return on the money provided to borrowers due to the decrease in purchasing power of the compensation they receive in the future.
- Supply and Demand
Like most things in a free market economy, interest rate changes can occur due to supply and demand. The supply and demand of “credit” is a major factor influencing interest rate levels, where an increase in demand of credit, cash, or simply put, money, will raise interest rates. While a reduction in demand for credit may cause the lowering of interest rates. In the alternative, a rise in the supply of credit may lower interest rates, while a decrease in the availability (again, the “supply”) of credit may increase rates.
An easy-to-follow, everyday example of this is when you deposit your earnings into a savings account with a bank to accrue interest. As you earn interest from the bank by keeping cash in the savings account, you are essentially “lending” money to the bank as the bank will use that money for its business operations (such as lending money to other customers) and investment activities. The more banks are able to lend, the more credit is available within the economy. Where credit supply increases, the cost of borrowing (interest) will decrease, and vice-versa.
- Monetary Policy
As mentioned earlier, when you hear the news mentioning phrases such as “expected interest rate increases” and “interest rate adjustment”, they usually refer to the impact of the decisions made by the Reserve Bank of Australia (RBA) and its board.
The RBA is Australia’s Central Bank which has legislative power to manage the country’s monetary policy and makes decisions to determine the “cash rate” – the interest rate at which banks pay other banks to borrow funds on overnight loans.
On the first Tuesday of every month (except in January), the RBA board meets to make a decision on the official cash rate: whether to increase, decrease, or maintain.
If the RBA lowers the cash rate, additional money will be available to banks to borrow. If the cash rate is increased, less funds will be available for banks to borrow.
It’s important to note that lenders have the freedom to set their own rates in-line with the cash rates, with the decision to “pass-on” interest rate changes up to the discretion of the bank.
Interest rate adjustments can have a major impact on households and small businesses. While reduced interest rates can provide respite in terms of lower debt repayments, increases in interest rates can be difficult for households and small businesses. Consolidating your debts and renegotiating your current interest rates are an option available to many to protect yourself from future interest rate increases.
When examining your financial situation, ensure that you look at how interest rates are tracking and factor-in an allowance for any further increases that could affect your payments, if necessary.