You might be surprised at what really drives interest rates

The Reserve Bank of Australia (RBA) and the major trading banks may play the most visible role in setting interest rates, but in many cases they are being reactive rather than proactive.

A wide range of external factors feed into their decision-making process, including in no small part, our collective behaviour as investors and savers, borrowers and consumers. Then there’s the rate of inflation and wages growth, foreign currency exchange, the economic health of our trading partners, and the interest rates paid by local banks to borrow money from overseas.

Suddenly it’s not so easy to figure out where interest rates are headed, even in the short term.

A fine balance

To look at just one part of the puzzle: the RBA dropped the cash rate to 0.10% in November 2020 – the lowest rate on record. This makes it cheaper for businesses to borrow and invest in job-creating activities. However, mortgage rates also followed the cash rate down, allowing homebuyers and investors to borrow more which subsequently drove up house prices.

So how can the RBA keep a lid on housing costs without choking business activity and consumer spending?

One way is to get by with a little help from its friends, in this case the banking regulator, the Australian Prudential Regulation Authority (APRA).

APRA is able to impose a range of restrictions on the banks. These include capping new interest-only lending, and limiting the growth in lending to investors. Lenders can also be ordered to keep a tight rein on ‘risky’ loans, for example, where loans exceed 80% of the value of the property.

While APRA’s main motive is to make the banks more resilient to any shocks such as another global financial crisis and the economic slowdown caused by the COVID-19 pandemic, a side effect is that the banks will have to reduce the amount they lend for housing. And according to the rule of supply and demand, if less money is available then the cost of that money – the interest rate – will go up.

Benchmarking

Interest rates in Australia are also affected by the Bank Bill Swap Rate (BBSW). This is calculated by the ASX at the same time every day and is based on the rates being bid and offered by approved trading institutions on short-term interest-bearing securities. General interest rates are set by financial institutions in reference to the BBSW.

Navigating uncertain waters

Appreciating the complexity of interest rates doesn’t always help in deciding how to respond to them. Even the experts often get it wrong when trying to predict where interest rates are going. This doesn’t help answer borrowers’ eternal question: “do I lock in a fixed rate, or opt for a variable rate?”

Locking in current rates provides protection against future mortgage rate rises. In the current low interest rate environment it’s very tempting to fix the rates on at least part of a mortgage, and for as long as possible (usually up to five years).

Based on recent activity, in the unlikely event that rates fall further, fixed-rate borrowers pay more. However, with rates already so low, any falls are likely to be small which can minimise the downside risk.

Still not sure what to do? If your mortgage is due for a review or you’re looking to invest or buy, talk to your licensed financial planner or mortgage broker to get a professional opinion.