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How is the cash rate different from the interest rate?

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By Lyndsey Douglas

There will always be pairings that we get mixed up when they're actually quite distinct from one another. Coles and Woolworths, Pepsi and Coke. The cash rate and the interest rate are two such pairings.

What is the cash rate?

The cash rate is a metric set by the Reserve Bank of Australia (RBA). Basically, it is the interest that every bank has to pay on the money it borrows, or in its own words, the "overnight money market interest rate". Banks process transfers between each other overnight, and the cash rate affects how much interest they pay on these transactions. 

Basically, it is the interest that every bank has to pay on the money it borrows.

On the first Tuesday of every month, the RBA meets and announces its decision on whether to change the cash rate or keep it steady. For example, as of April 2016, the RBA had kept the cash rate steady for 12 months in a row. In May,  the cash rate was dropped by 0.25%.

The RBA changes the cash rate for a number of reasons - to spur borrowing and spending among businesses and banks, to keep inflation in check, or to make sure the Australian dollar doesn't get too strong or weak overall.

How does it relate to interest rates?

As we noted above, the cash rate dictates how much interest banks pay on their overnight borrowing. This affects your interest rate as the costs can be passed down to consumers, resulting in higher rates on Australian home loans.

So, banks don't necessarily have to raise or cut interest rates when the cash rate fluctuates, it opens the door a little wider for such changes. 

It isn't the only reason interest rates rise or fall, though. For example, late in 2015 many lenders increased interest for owner occupier and investor home loans because of increased capital requirements. Essentially, this meant banks had to have more money stored on a permanent basis, which was enough to hike interest for consumers.

Additional factors

Of course, your home loan interest rate calculations won't be as simple as this. The risks associated with your mortgage will also affect the interest rate you get - this can include your deposit, your income and loan-to-value ratio. Additionally, interest rates incorporate enough of a difference from the cash rate to ensure a decent rate of return as well. They wouldn't be a bank if they weren't making any money!

The performance of Australia's import and export markets can also affect interest rates through the cash rate, as the RBA seeks to maintain that aforementioned balance in the national dollar. 

How should you act?

When you're looking at deciding on a home loan, the cash rate will undoubtedly be something to factor in. Unfortunately, there are so many variables involved that it tends to get a bit overwhelming. That's where using a financial planning professional can really give you an edge, helping you understand what influences the interest rate and how your home loan schematics could change over time. 

One survey from Yellow Brick Road actually found that only 22 per cent of of adult respondents used a financial adviser, and most of those people are over 55 years of age.

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