Finance explained: interest rate rises, drops and you
You may hear on the news the first Tuesday of each month that interest rates might be moving. Depending on economic conditions they can rise and fall. You may think that a rise in the interest rates is only important to people who have a mortgage. Higher interest rates mean bigger repayments and a tougher time for people on a budget. In reality, the overall interest rate set by the Reserve Bank effects everyone who uses money in Australia – you, the team at Smallloans.com.au and everyone around you.
What do people mean by “interest rates?”
The interest rate that’s announced on the nightly news or talked about in the columns of newspapers and online is literally the “cash rate charged on overnight loans between financial intermediaries.” Sounds a bit complicated, but it’s essentially how much the Reserve Bank charges its customers – the big banks – to borrow from one another overnight. Think of it as the official price of money from the biggest bank in the land. This is known as the “official cash rate” or OCR.
OCR and interest rates generally
An OCR set by the Reserve Bank is the first line in the chain of credit for all Australians, as far as the price of borrowing is concerned. For all intents and purposes, the OCR is the official price of money in Australia.
OCR in action
Let’s say the banks are being charged 5% interest rates on their transactions with the Reserve Bank. Banks make that money back by charging consumers an interest rate. This interest rate will hover pretty close to the OCR. So if the OCR is at 5%, long-term loans such as mortgages should fall in line with that OCR.
Why can’t a bank just charge whatever they like?
They absolutely can. They will go out of business pretty quickly, though. That’s because there’s intense competition from big banks, small financiers and other institutions when it comes to providing finance.
It’s a good business decision for a bank to match its long-term lending rate with the OCR. Banks who are greedy and don’t pass any cuts in the OCR rates on to their customers means they could lose their business to competitors. So the whole economy doesn’t undergo a massive shock, changes to the OCR are made in increments, usually in 25 basis point steps.
What is a basis point?
Basis points are one one-hundreth of a percent, so 25 basis points means 0.25%.
What about car loans and personal loans?
Yes, car loans, personal loans and even credit cards are affected by the OCR. The OCR is the starting point for how much money costs to borrow in general. If the OCR goes up or down, so do variable loan rates such as car loans or credit cards because the cost of the money has to be recouped at every step of the chain. Read more on our blog post about these types of loans for more.
When interest rates go up, your savings do too
The OCR isn’t just limited to how much banks charge for loans. People with substantial savings accounts will benefit from a rise in the OCR. The OCR also effects how much interest you will earn on deposits you have with your bank. This is almost by design, as increases in OCR means the Reserve Bank wants people to save their money so it positively affects the rate of inflation.
Want to know more?
For more technical information about the OCR and what the Reserve Bank does, head to the official Reserve Bank of Australia website.