There is a lot of confusion about interest rates and why they move as they do:
- Why do the banks only pass on half of the rate cut to their home loan customers when the Reserve Bank (RBA) moves the cash rate down by 0.25%?
- Why do the banks move their rates down, even when the RBA doesn’t move the cash rate?
- Why do the major banks, customer-owned banks, credit unions and building societies, and the mortgage originators, such as mortgage brokers’ interest rate movements fall out of sync with the RBA?
- Where do fixed rates come into the picture when it comes to the RBA cash rate moves?
1. The Reserve Bank cash rate sets home loan borrowing rates
Verdict: This probably is, or maybe was, the most widely held myth.
The RBA does not set home loan rates. Most home loan borrowers will have realised this over the last 6 months. If they have not, they must think that the banks are somehow breaking the rules.
The home loan rates are set by the individual banks (and here I include the credit unions, building societies and mortgage brokers). Governments, politicians, the Australian Prudential Regulatory Authority (APRA), and the Australian Competition and Consumer Commission might all at one time or another apply pressure on the banks to move their interest rates, but they don’t make the call in our de-regulated market.
The banks make the pricing decision based on their cost of funding loans, their cost to deliver and service loans, their required return on shareholders’ funds, and the competitive state of the market.
2. The home loan contract is one of the strangest contracts you will ever agree to
Verdict: This one is not a myth.
When you sign a contract to rent an apartment or build a house, buy a car, sign up to a phone plan, or for almost anything else, you sign up for the service for a price fixed for the term of the contract. This is not so for a variable rate home loan, where you sign up to repay the loan over 25 or 30 years, but the price (the interest rate) and therefore the repayments can change, at the bank’s option. It’s even true for fixed rate loans, where the rate remains steady during the fixed term, but then converts to variable.
So, why does a variable rate home loan not fit the norm? It’s because the term of a home loan has to be very long in order to allow it to be affordably repaid. This means that the bank has to fund the loan every year for its 25-year life, and it is not possible to viably fix the funding cost for that long.
Think of how it differs from buying a car. With a car, the manufacturer builds the car at a cost overseas, and it is imported and wholesaled to a dealer who sells it to you. On the way, all of those parties have incurred their costs upfront and applied their margin, and it is sold to you for a price that covers all that. The parallel with a home loan is that the bank has to fund the loan again every year or two, so their cost of manufacturing is effectively ongoing for the full 25 years of the loan.
Hence the variable and one-sided nature of the home loan contract.
3. The RBA sets the cash rate on the first Tuesday of each month
Verdict: This one is half a myth.
The RBA is not setting the cash rate, it is setting a target for the cash rate, which acts a signal to the market about the management of the money supply through the RBA’s open market operations.
More on this to come, but first up, what is the cash rate? It’s the rate at which banks borrow from the RBA overnight, when they require funds to settle transactions at end of day.
The banks can borrow from the RBA or the market, and if the RBA has managed money supply as it expected, the price at which banks will borrow from RBA will be the target cash rate. The “hoopla” over the cash rate announcement is because it is an immediate signal to the market about the RBA’s intent to manage money supply to certain settings, and it enables the banks in turn to make interest rate decisions.
It is this mechanism that sees cash rate changes passed through to other interest rates in the market – home loans, savings accounts, business loan rates, etc.
4. The banks should pass on the full amount of a RBA cash rate decrease, every time
Verdict: Sorry, another myth.
In a world where all costs are directly and equally impacted by the RBA cash rate, this could possibly be the case. But we don’t live in that world.
The bank has costs in delivering the loan to you and in providing ongoing administration and reporting to you. These bear no relation to the cash rate.
The bank has to earn a return on its loan if it hopes to stay in business and pay shareholders a dividend. Government regulation via the Australian Prudential Regulatory Authority determines how much of shareholders’ funds are required to support a loan – and when this changes, as it has been announced recently (in respect of the big four banks), this “cost” goes up. However, it’s only marginally related to the cash rate.
The big item in the equation is the funding of the loan, which again is only partially related to the cash rate. In addition to shareholders’ funds, the banks fund loans through deposits and wholesale fund raisings from institutions like superannuation funds. Deposits raised from Australian customers’ deposits represent around about 60% of the mix and are directly related to cash rate settings, but not perfectly and equally (given the mechanism described above). Wholesale raisings are impacted by Australia’s sovereign debt rating and the bank’s credit rating, and also by market conditions in international debt markets, exchange rate changes, liquidity in markets, etc. In particular, where these funds are raised overseas, they bear only peripheral relationship with RBA cash rate moves.
In short, the RBA cash rate signals the direction of the likely movement, but the mix of a bank’s funding sources and costs is what leads banks to determine how much they can pass on to borrowers.
5. All institutions are faced with the same cash rate change and should pass on the same amount
Verdict: Another myth.
Life is not that simple. Every lender has a different cost structure made up of the mix of costs and funding sources outlined above.
At times, this might favour the big banks who have economies because of the size of their home loan book and who raise funds in wholesale markets, which are sometimes more cost effective.
At other times, it might favour the credit unions, which rely more on deposits from Australian customers.
Still other times, the mortgage originators, which raise their funding through loan securitisation (think on-selling their loans), can come out on top.
Pricing pressures are going to favour these groups differently at any one time, and mean that they will sometimes be passing on a different proportion of an RBA cash rate cut.
6. Consumers are powerless when faced by a bank interest rate increase and just have to pay more
Verdict: Very much a myth.
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