Interest Rates – No Change As Expected

So, as expected, yesterday the Reserve Bank of Australia (RBA) left interest rates unchanged at 1.5%. This is the 12th meeting in a row, where all the members of the RBA have gotten together, thought about the state of the Australian economy and decided, “you know what, things are about right”…. In fact, the last time they decided to change the Official Interest Rate was late August last year, the 3rd of August 2016 to be exact. Back then the economy was looking a bit shaky, and they wanted to encourage people to spend more and save less (hoping this extra spending would mean more revenues for companies who in turn would hire more Australians to do  the extra work). To do that, they made money cheaper, by reducing the interest rate from 1.75% to 1.5%.

And that’s where it’s been ever since.

Wait what!??
For some of you, this may have been a bit of a WTF moment. The official interest rate is 1.5%?? But I’m paying 4.00% on my home loan and my credit card charges me 19% on outstanding balances. What’s going on?

Ok time for some boring stuff. Don’t get mad, you asked. Or maybe you didn’t. But let’s pretend you did.

There are three things which determine the interest rate you pay for borrowings and they all come down to different versions of risk:

  • How risky you are: What is the likelihood of you paying back your loan to the bank
  • How long are you borrowing money for: The longer you borrow money, the more chance there is that your situation could change and be unable to pay back your loan
  • Whether you have any collateral (ie stuff) which the bank can take off you, should you be unable to pay back your loan: If you can’t pay back your loan, the bank can “repossess” your stuff, and sell it, to help pay back your loan.

So in that context, the 1.5% official rate the RBA has set is the rate for overnight borrowing by a riskless borrower. Or in other words, it is the rate of interest someone would pay to borrow money today and with the promise of paying it back tomorrow, where the lender is 100% certain that the debt will be repaid in full.

Any other kind of loan or borrower, will be charged a rate in addition to this 1.5% to compensate the bank for one or of all of the above three risks.

And that is why the RBA’s interest rate decision is so important and why the media covers it so widely. The official interest rate (now 1.5%)  is effectively the reference point for which every other loan in Australia is based off.

Home Loan
With a home loan, you’re borrowing money for a very long time (quite often upwards of 25 years). Not only that, you’re borrowing a very large amount for a very long time. However, should you default on your loan, the bank gets to repossess your property and then sell it. You home loan is a “secured loan”, secured by your property.

The fact that you’re borrowing for such a long period of time, increases the risk to the bank and therefore increases your borrowing rate. However the fact that the bank can sell your home if you default, helps to somewhat reduce the banks risk and in turn bring your borrowing rate back down again. All in all, the bank deems the 4%  rate to be “about right” to compensate them for all of this.

Credit Card
For your credit card, there is no set time for the loan. It is almost a “forever” loan. You should pay it back, but there is not contractual length of when you need to. This makes it risky for the banks, as they have no idea when they will be getting their money back. And worse, if you don’t pay it back, they have nothing of yours (ie collateral) they can sell, to cover their losses. Therefore credit card debt is “unsecured debt”.

Because of all that, they slap on a 20% interest rate. It’s steep, its expensive. In fact it’s probably the most expensive kind of loan you can get. Credit card debt is the single worst kind of debt you can have.

Anyway, that’s 5 minutes. Hope it helped.

Categories: Investing

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