KEY TAKEAWAY: The Reserve Bank of Australia strongly influences the interest rates that financial institutions charge their customers for loans.
Who or what is the RBA?
The RBA is a body corporate wholly owned by the Commonwealth of Australia. It is not a commercial bank and cannot provide banking facilities to the general public. However, it provides certain banking services to the Australian Government and its agencies, and to a number of overseas central banks and official institutions.
The Reserve Bank Board has up to nine members who are appointed by the Treasurer. Three of the roles are ex officio: the Reserve Bank Governor (Chairman), the Deputy Governor (Deputy Chairman), and the Secretary to the Treasury. The remaining six are non-executive members. The Reserve Bank Governor and the Deputy Governor are appointed for terms of up to seven years. The other six members are appointed for terms of up to five years.
What does the RBA do?
The Reserve Bank of Australia (RBA) is Australia’s central bank. Its functions and powers are set out in the Reserve Bank Act 1959. In addition to issuing the nation’s banknotes, the RBA’s main roles include contributing to:
- The stability of the currency of Australia
- Maintaining full employment in Australia
- The economic prosperity and welfare of the Australian people
- Promoting the safety and efficiency of the payments system
- Managing Australia’s gold and foreign exchange reserves
The RBA also sets the official cash rate (OCR) to meet an agreed medium-term inflation target. Changes to this rate have widespread effects for the economy as a whole.
What is the official cash rate?
Every month (except January), the RBA Board meets to decide on the most suitable monetary policy for Australia’s economy. This policy involves setting the cash rate.
The official cash rate is the amount of interest a commercial bank must pay the Reserve Bank if it takes out an overnight loan. This in turn influences the rate at which these banks lend money to the public. It also serves as a benchmark rate in the country.
For example, if Westpac borrows $500 from the Reserve Bank overnight, under the current regime, it would pay the Reserve Bank an extra $10 per annum for the privilege. This is about 0.27c a day.
So why do banks need to borrow overnight?
Banks lend money to other banks each day to maintain daily cash needs, and these loans are known as ‘overnight’ funds due to their short loan term.
Due to the daily value of any one transaction (whether $5 or $5 million) and because banks are risk-taking institutions, they may temporarily run out of hard cash to make good on their transactions. As they are legally bound to settle the transaction overnight, they must borrow from each other or the Reserve Bank .
When the cash rate is low, borrowing overnight from the Reserve Bank is quite cheap. This means banks can take bigger risks and lend more money to households and businesses.
This stimulates economic activity, but more bank lending means a higher chance of banks running out of money. When the cash rate is low, the cost to a bank of running out of money is not as substantial.
How does the RBA affect my mortgage?
A rise or fall in the cash rate often leads to a change in the interest rate for mortgages, loans, and savings. If the Reserve Bank lowers the official cash rate, it might make banks more willing to lend to new homebuyers. However, in a free market, the bank has a choice in deciding how it responds to a potential cash rate decrease. It is in their best interest, however, to pass on the cash rate cut to its customers to eliminate the risk of losing customers and damaging its public image.
When we face economic prosperity, our wages increase and unemployment is low. Interest rates are usually low at the beginning of this boom, so people are in a better position financially to afford bigger mortgages. This in turn drives both housing prices and inflation up. The economy is unable to keep up with growing aggregate demand, so the RBA compensates by increasing the cash rate to make credit less affordable. Then, it becomes harder to pay the mortgage, which reduces spending and leads to an eventual cooling of the market.
Buying in a boom means a high purchase price (which may fall) and low interest rates (which may rise.) On the other hand, buying when real estate prices are low usually means a high interest rate (which may fall) and a low value (which may rise).
It makes sense to buy in a low period, but only if you can afford the repayments.
For those homeowners with variable rate loans, rising interest rates can cause financial panic. A higher rate means paying more interest on the money borrowed.
The situation is a little different for fixed rate loans. Whilst borrowers are protected against any rate rises, they won’t be able to take advantage of any rate decreases when they occur.
Understanding how the RBA works is one thing - using the cash rate to your advantage is another. Ask your local mortgage broker about your current home loan and if now is the right time to refinance.
Disclaimer: The advice provided in this article is general advice only. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this advice you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. We encourage you to consult a finance professional before acting on any advice provided in this article or on this website.