Broadly speaking, the Reserve Bank of Australia (RBA) has three main responsibilities:
1. the stability of the currency of Australia;
2. the goal of full employment in Australia; and
3. the economic prosperity and welfare of the people of Australia.
One of the ways it influences to achieve these targets is via the implementation of monetary policy, which involves setting the interest rate (or cash rate) for Australia.
In terms of interest rates, the RBA made the decision to cut rates twice last year, firstly in May 2016 to 1.75 per cent and then again in August 2016 to its current historic low of 1.50%. This rate influences the interest rates that lending institutions apply to loans and deposits.
Changes to the interest rate can have a huge impact on the economy, so predicting what the RBA will do with the interest rate is an important role for economists.
Before an economist reaches a decision on their predicted forecast for the interest rate, they will generally assess a number of important factors, such as:
- What was the RBA’s last decision and commentary regarding the interest rate?
- Is the Australian Dollar rising or falling?
- What are the current national employment figures?
- What’s the current economic outlook?
- How are property prices trending and what’s the overall performance of the housing sector?
- What’s the level of consumer and business confidence?
- What’s the global economic, political and market situation?
A current belief held by many economists is that there is at least one more interest rate cut expected from the Reserve Bank in 2017 assuming employment, wages growth, and household spending continue to remain sluggish. According to the expectations of Trading Economics, the interest rate is projected to stay at 1.5% in early 2017, move towards 1% in late 2017 and then trend upwards to 3.50% in 2020 – the last time the official cash rate increased was November 2010.
What does this mean for you?
When a decision is made by the RBA to alter the existing interest rate, financial institutions usually - follow suit and adjust their lending rates by moving in the same direction by increments of 0.25%, whilst still maintaining a profit margin of approximately 1.8 to 2.5%. The end result is a rate that financial institutions lend to borrowers for loans and mortgages.
In terms of households, changes in the interest rate can make a substantial difference to the finances of everyday Australians, including the interest rate charged on your home loan. For example, if you have an existing variable rate home loan, your lending financial institution will generally increase the interest rate on your loan by whatever increase the RBA makes to the interest rate (or decrease it if the opposite occurs). Financial Institutions do not necessarily mirror the exact decrease or increase; other factors may see these institutions apply a different percentage change to the RBA’s movements.
Although, interest rates are predicted to drop initially in 2017, let’s look at an example of the potential implications of a future interest rate rise.
Ray and Liz Jones recently decided to purchase a residential home with help from their financial institution with a $500,000 variable home loan with a loan term of 30 years. On their current lending rate of 4% (assuming 1.50% RBA interest rate plus a 2.5% financial institution margin) the monthly repayments are $2,387.08 and the interest paid over the life of their loan is targeted at being roughly $359,348.
However if we looked to the future and the predicted 2020 interest rate rise to 6% (3.50% RBA interest rate plus a 2.5% financial institution margin), then their monthly repayments would increase to $2,997.75 ($610.67 extra) and the interest paid over the life of their loan would increase to roughly $579,191 ($219,843 extra).
We don’t have a crystal ball when it comes to what the future may hold, and these interest rate predictions are open for revision over time. There are strategies that we can utilise in the present, in conjunction with the information that is available to us, to make informed personal finance decisions. In terms of interest rates, it is always worth considering what an interest rate rise may mean for your household and to ensure you aren’t overextending yourself. If you have an existing mortgage, revisit or consider the option of employing debt reducing strategies such as establishing an offset account and redraw facility, as well as making extra repayments and potentially refinancing your home loan.