What the heck is the Official Cash Rate and how does it affect interest rates?

Once you cross to the dark side and become mortgage adjacent (that is, you either have one, or you want one), the cash rate becomes a hot topic of conversation. But what actually is it, and how does it affect you?

Remember, any advice provided on this website is of a general nature only and does not take into account your personal needs, objectives and financial circumstances. You should consider whether it is appropriate for your situation.

What is the cash rate?

Put simply, the cash rate is a central rate set by the Reserve Bank of Australia (RBA) that defines how much it costs for banks to borrow money from one another overnight. Yeah, they do that!

The interest rate banks and financial institutions charge us as borrowers (or pay us on our savings) is partly defined by the cash rate. The difference between the two rates forms part of the bank’s profit. Because, like any business, banks have to try to maintain a profit margin, if their costs increase with changes to the official cash rate, they pass them on to customers with increased borrowing and deposit rates.

As an example, if the cost of eggs soared, your local brunch spot would probably raise the price of egg dishes. In a similar way, banks raise their rates when the cash rate increases to keep their profits stable. Just like the brunch place owners, banks need to pay their staff, cover stuff like rent and shareholder expectations, and have enough money left over to be there next year and the year after next.

Meet the Reserve Bank of Australia

The Reserve Bank of Australia sets the official cash rate and decides whether to update it each month based on a variety of economic factors. Their job is to steer the economy and maintain stability and balance. When things tip off balance, the RBA may change the cash rate in response. That’s because the cash rate actually plays a large role in how we as consumers spend and save our money.

The RBA, the cash rate, and the economy

A strong and thriving economy relies on all kinds of spending, from houses and investments to shoes to entertainment. The economy needs money to be moving around to stay strong. But sometimes this spending gets out of control, pushing up the cost of everything (aka inflation) and threatening a ‘boom or bust’ scenario.

When this happens, the RBA may increase the cash rate to curb spending and cool down the economy. On the flip side, when the economy slows down, the RBA may lower the cash rate to stimulate spending.

Side note: other factors go into determining the cash rate, too. But it gets real tricky real fast: balancing economic growth and stability is the big one.

Why does raising the cash rate change how much we spend?

When the official cash rate changes, banks and financial institutions tend to pass some or all of the increase or decrease onto their customers. How much they pass on depends on a few things – all of their businesses work differently – but they tend to move fairly closely together.

This impacts our behaviour as everyday savers and borrowers because the rate of interest available to us affects how much money we have available to spend.

For example: if the cash rate rises from 2.00 per cent to 2.25 per cent, banks may increase mortgage rates from 4.75 per cent to 5.00 per cent and savings account rates from 1.00 per cent to 1.25 per cent. When mortgage rates go up, people have less available to spend each month, and are also less likely to borrow to buy property because the cost of interest has increased. As for savings, an increase in interest payments means people are more likely to stash than splash.

Likewise, if the cash rate drops from 2.25 per cent to 2.00 per cent and that is passed on via lower mortgage rates and lower savings account rates, we’re more likely to take out loans because it’s cheaper to borrow, and more likely to spend because we’ve more left in our pockets. Plus, there’s less incentive to hold cash when our savings accounts are paying a pittance!

Is the cash rate the same as my interest rate?

No. The cash rate isn’t the figure you can expect to pay or earn with your bank or lender. That’s because they need to make a profit on the money they borrow and lend. (Just like that brunch spot that can’t give you free eggs *and* stay in business).

Can I avoid cash rate changes impacting my loan repayments?

Kiiinda? What you can do is avoid uncertainty, by choosing a fixed rate loan. With a fixed term loan, you tell your lender how long you’d like to lock in your rate for, and they tell you what rate they’re willing to offer you for that length of lock-in. It might be higher than the variable rate but you can be sure what your repayments will be over that period of time.

Fixed rates can offer protection against potential future rate increases, but, you also won’t benefit if rates go down.

What do I need to do when the cash rate changes?

Essentially, nothing. The cash rate may impact your savings or loan rate, but this all happens automatically, and you’ll be notified of the change when your lender makes it.

It is however worth keeping an eye on the cash rate change each month, as this acts as an economic indicator and helps you make a guess about what to expect in your wallet going forward.