Explainer: What’s going on with the RBA cash rate?

How the RBA cash rate works, why it affects savings and home loans, and where to get the best value right now.

Last week the Reserve Bank of Australia (RBA) cut the cash rate for the second time in almost a decade. This means Australian homeowners will be paying less on their mortgages, while Australian savers will earn less interest on their savings. Why does the cash rate affect these products? What actual effect have the recent cuts had on the market and what's in store in the near future? This simple explainer will take a deep dive into those questions.

What is the RBA cash rate?

The cash rate is set by the RBA on the first Tuesday of (almost) every month and determines the cost that other banks pay to the RBA to borrow money. This, in turn, affects the amount that commercial banks charge their customers on loans. If the RBA drops the cash rate, banks are able to access cheaper loans and competition encourages them to pass most (but not all) of those savings onto their customers. Thus, the cash rate is directly related to the interest rate homeowners pay on their mortgages.

Additionally, if accessing funds becomes cheaper for banks, they have less incentive to encourage their customers to deposit funds in their vaults, so they'll be inclined to reduce the amount of interest they pay on savings accounts.

How has it changed?

The RBA made its first cash rate call in January 1990, when it set the cash rate to 17%. That may seem absurdly high by today's standards – and in fact it has been very much downhill from there. Within three years, the figure had fallen to 4.75%.

The cash rate bounced around a bit over the following years, taking a steep dive to 3.00% following the global financial crisis. It recovered slightly but then started a slow decline. In September 2016, the cash rate fell to 1.5% and didn't budge for 34 months. June and July's cuts have resulted in an all-time low cash rate of 1.00%.

Why do we use basis points?
When discussing changes in rates over time, economists tend to talk about basis points rather than percentages. This is important, because percentages can be misleading. For example, it might be tempting to refer to a cash rate drop from 3% to 2.5% as a "half-percent drop". In reality, a half-percent drop would mean the original figure was reduced by half a percent of its total value – in this case, it would mean a new figure of 2.985%. To avoid this confusion, the phrase "basis point" is used to refer to every 0.01% change in a rate. The change here would be more correctly described as a 50 basis point drop.

What impact will this have on savers?

Things look pretty grim for savers right now in Australia. Many banks will offer a snazzy introductory rate on their savings products which drops dramatically after three or four months. The average standard savings rate across the market currently stands at only 0.60% according to the RBA itself. Not a lot of room here for a 25 basis point cut.

Marginally better rates are available in what the RBA calls "bonus savings accounts". These are savings products which offer an ongoing bonus rate as long as a deposit is made into the account each month. Some of these accounts do not allow any withdrawals at all, while others allow some as long as the amount deposited each month is more than the amount withdrawn. These bonus accounts are currently offering 1.95% p.a. on average according to RBA data, with the caveat that your savings are not very accessible.

The best rates, though, can be found with online banks such as UBank, ING and ME Bank. These also offer accounts with ongoing bonus interest, but the rate is unlocked in this case by doing your everyday banking with the bank via an associated current account. As long as your wages are paid into the account and you make a few debit purchases each month with your debit card, you get the rate. These are offering 2.60%, 2.35% and 2.30% respectively. Keep an eye on Finder for the highest interest savings accounts.

According to Finder's consumer sentiment survey, the average Australian reports having around $30,000 in their savings account and saves around $650 per month. UBank's current bonus rate of 2.60% would pay $1,994 in interest over 2 years in this scenario. A 50 basis point drop to 2.10% would result in the same savings earning only $1,604 over the same period, which is a $391 drop.

What about home owners?

Sydney's average house price right now sits at around $900,000, depending on which source you get your number from. Assuming an industry-standard 20% deposit, buying the average home in Sydney right now would mean borrowing $720,000 from your bank.

The average standard variable rate across the market sits just north of 5%, with several lenders yet to apply cuts to their rates. If you were to take out a home loan at 5% p.a. (better rates are available), you would be paying a monthly mortgage of $3,865. Over the course of a 30-year loan, this would end up costing $1,391,442, with $671,442 of that being interest. You may be surprised by these figures – I certainly was the first time I calculated what the mortgage would cost on my first home.

If our theoretical bank in this situation were to pass on both of the RBA's recent rate cuts in full, our variable rate would drop to 4.5%. This would drop the monthly cost of the loan by $217 and save $78,113 in interest over the full 30 years. As you can see, interest rate cuts can mean significant savings for homeowners.

Why would the RBA cut the cash rate anyway?

As we've seen, even a single 25 basis point cut can mean significant savings for mortgage holders, meaning Australians have more money in their pockets. It also discourages people from saving, because they earn less interest on their money. One of the hopes in cutting the rate is that these two things will combine to encourage households to spend extra cash. This, in turn, should stimulate the economy.

Additionally, the theory goes that cheaper home loans will make housing a more attractive investment option. This, combined with APRA's lowering of serviceabiltiy guidelines and some certainty from the presumed continuation of negative gearing, has contributed to house prices rising slightly in Sydney, Melbourne and Hobart recently.

Will these cuts be enough to stimulate the economy and turn the price increase into an upward trend? Time will tell.

Graham Cooke's Insights Blog examines issues affecting the Australian consumer. It appears regularly on finder.com.au.

Picture: Getty