Interest and Cash Rate: the difference and why it matters to you

08th Oct, 2021 | Articles, First Home Buyer, Investor, Refinance

In this article:
What is the cash rate? How is it different to an interest rate? Why does it change? How does it affect interest rates? What does it mean to me as a homebuyer? The answers can all have an impact on how much money you might be able to borrow.

Basically, the cash rate is the interest that every bank has to pay on the money it borrows, or in its own words, the “overnight money market interest rate”. Banks process transfers between each other overnight, and the cash rate affects how much interest they pay on these transactions. The cash rate is a metric set by the Reserve Bank of Australia (RBA) – the central bank of Australia and the the ultimate decision maker for monetary policy in the country.

On the first Tuesday of every month, the RBA meets and announces its decision on whether to change the cash rate or keep it steady. For example, in November 2020, the cash rate was decreased to an all time low by the RBA at 0.10% and has been unmoved since. In fact, it’s been over 10 years since the RBA has raised the cash rate in Australia.

Why would the RBA change the cash rate?

The RBA changes the cash rate for a number of reasons – to spur borrowing and spending among businesses and banks, to keep inflation in check, or to make sure the Australian dollar doesn’t get too strong or weak overall. What does this mean for you personally when rates go up or down?

When rates go up, it is good news for savers but bad news for borrowers. This can be a great thing if you already have money saved up and are looking to invest or buy something expensive. On the other hand, when rates go down, it is very beneficial especially during times of financial hardship – borrowing becomes cheaper so more people can afford it.

Is the cash rate the same as an interest rate?

No, but they are related. The cash rate is reflects the overnight lending rate from the RBA to the banks, or simply, it specifies how much interest banks must pay on their short-term borrowing. It has an impact on your interest rate since the expenses can be passed down to customers, resulting in higher or lower rates on Australian home loans. So an interest rate is the price of borrowing money from your lender.

Banks don’t necessarily have to alter their interest rates when the cash rate rises or falls, but when the RBA lowers the cash rate, it can encourage banks to do the same with their own interest rates.

Even a minor drop in interest rates can result in substantial savings over the life of the loan, as well as on monthly mortgage payments.

Lower interest rates often leads to an increase in borrowers looking to take advantage of affordable interest rates. Over recent months, with the cash rate steadily set at an all time low of 0.10%, interest rates have also been at record lows. The natural result has been a competitive housing market, driving up house prices in certain areas of the country.

What other factors are influential on determining an interest rate?

Naturally, your home loan interest rate calculations won’t be as simple as looking at the cash rate. Your personal financial situation, as well as your mortgage’s risks, will also have an impact on the interest rate you receive – this might include your deposit, your income and loan-to-value ratio, your credit history, and the availability of collateral. Furthermore, the interest rates are enough of a difference from the cash rate to provide a decent return for the banks. After all, they wouldn’t be a bank if they weren’t generating some profit!

Factors that impact on the cash rate will also affect the interest rates you see. For example, Australia’s import and export market can have an impact on interest rates, as they’re a key factor in the RBA seeking to balance the national dollar. So if the import and export market is performing well, there may be a flow on affect influencing the cash rate, and therefore influencing interest rates.

So what do I do?

When considering home loan options, the cash rate will almost certainly be one of your considerations. Unfortunately, there are so many variables involved in this process that it can be intimidating, particularly if you’re just starting out. That’s where using a financial planning professional can really give you the upper hand, helping you understand what influences the interest rate the impact this may have on the progression of your mortgage.

One survey from Yellow Brick Road actually found that only 22 per cent of of adult respondents used a financial adviser, and most of those people are over 55 years of age.

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