Australia has witnessed a significant shift in its monetary policy landscape, with the Reserve Bank of Australia (RBA) raising benchmark interest rates. As of May 3, 2023, the benchmark interest rate stands at 3.85%, a stark contrast to the 0.10% recorded in April 2022.

Why the increase, and how do these rate hikes affect the nation’s economy, businesses, and consumers? That’s what we will discuss in the following sections.

What are interest rates?

Interest rates are a fundamental concept in finance and economics. They show the price of borrowing money or the money you can make by saving it. Interest rates help money move between savers and borrowers in an economy. They are shown as a percent of the main amount, usually for a year. Things likemonetary policy, market conditions and the creditworthiness of borrowers influence them.

There are several types of interest rates, such as:

• Nominal interest rate: This is the most basic form and shows the cost of borrowing or the money made from saving without thinking about inflation. It is commonly used in loan agreements, savings accounts, and fixed-income investments like bonds.
• Real interest rate: This rate considers rising prices and shows the true buying power gained or lost over time. It is found by taking away the rate of rising prices from the nominal interest rate. It is particularly useful for long-term financial planning and comparing investments in different economic environments.
• Effective interest rate: This rate takes compounding into account, which is when interest is added to the main amount from time to time. The effective interest rate shows the real cost of borrowing or the true money made when compounding is included. If you take out loans, such as mortgages, personal loans, or car loans, for example, and the lender uses compounding, knowing the effective interest rate this helps you compare different loan offers and understand the total cost of borrowing.

Let’s look at practical examples for each type of interest rate:

Nominal interest rate

Let’s say you deposit $1,000 in a bank with a nominal interest rate of 5% per year. After one year, you would earn $50 in interest (5% of $1,000). This is the basic cost of borrowing or return on investment without accounting for inflation.

Real interest rate

Now, let’s say the inflation rate is 2% for that year. To find the real interest rate, you subtract the inflation rate from the nominal interest rate (5% – 2% = 3%). So, the real interest rate is 3%. This means that the actual purchasing power of your $1,000 has increased by 3%, considering the effect of rising prices.

Effective interest rate

Now let’s imagine the same bank account with a nominal interest rate of 5% but with interest compounded quarterly (four times per year). To find the effective interest rate, you can use the formula:

Effective Interest Rate = (1 + (Nominal Interest Rate / Number of Compounding Periods))^Number of Compounding Periods – 1

In this case, Effective Interest Rate = (1 + (0.05 / 4))^4 – 1 ≈ 5.095%.

So, with compounding considered, your actual return on investment is 5.095% per year. After one year, you would have approximately $1,050.95 in your account, which includes the interest earned due to compounding.

Who determines the interest rates in Australia?

In Australia, the Reserve Bank of Australia (RBA) is the central bank responsible for determining the benchmark interest rate, known as the cash rate. The RBA is an independent group that works to keep prices stable, make sure there are enough jobs and help the economy and well-being of Australians.

The Reserve Bank Board, which consists of the RBA Governor, the Deputy Governor, the Secretary to the Treasury and other high-ranking officials, meets eleven times per year (approximately once per month) to discuss the nation’s economic conditions and decide on the appropriate cash rate. When setting the cash rate, the Board considers factors such as inflation, economic growth, employment and international developments.

Even though the RBA decides the cash rate, other banks and financial companies set their own interest rates for things like loans, mortgages, and savings accounts. These banks and companies think about the cash rate when deciding their interest rates because it affects how much it costs to borrow and lend money between banks. So, when the RBA changes the cash rate, it often leads to banks and financial companies changing the interest rates they offer to people.

Why are interest rates going up in Australia in 2023?

Interest rates have increased in Australia in 2023 due to a combination of factors, including inflationary pressures, monetary policy decisions, economic recovery and global factors. Let’s take a closer look at each of these contributing factors:

Inflationary pressures

Rising inflation is a significant concern for any economy. When prices keep going up, people worry because they can’t buy as much with their money. This can hurt the economy’s growth. To help fix this, central banks sometimes increase interest rates. This makes people spend and borrow less, which can slow down how fast prices rise.

In Australia, the high inflation rate is caused mainly by:

• COVID-19 pandemic. The pandemic has caused disruptions in global supply chains and production, leading to shortages of goods and higher production costs.
• Russia’s invasion of Ukraine. This event has caused additional disruptions to global markets, especially in energy and commodities. As a major exporter of resources, Australia has been affected by these changes, leading to increased prices for some goods.
• Strong consumer demand. With the easing of pandemic restrictions and people returning to normal activities, there has been a surge in consumer spending. This increased demand for goods and services can push prices up, contributing to higher inflation.

Monetary policy decisions

The RBA has proactively adjusted its monetary policy to maintain price stability and control inflation. To achieve these goals, the RBA has been raising the cash rate, which in turn influences other interest rates in the economy. These higher interest rates aim to encourage saving, reduce borrowing, and ultimately help control inflation.

Economic recovery

As the Australian economy heals from the challenges brought on by the COVID-19 pandemic, people are eager to return to normal life, resulting in a growing demand for goods and services. However, the supply is not back to normal. This increased demand and lack of supply contribute to rising inflation. In a caring effort to maintain balance and protect the economy from overheating, raising interest rates becomes a necessary response to help manage this renewed enthusiasm and support a stable recovery.

Global factors

International events and trends can affect interest rates in Australia too. For example, if interest rates go up in big countries like the United States, it can make the central bank in Australia want to do the same. This is because higher interest rates in other countries can change how money moves and the value of currencies. Also, changes in prices of things like oil, how countries trade with each other, and political problems can make prices go up and change decisions about interest rates.

What is the highest that interest rates have been in Australia in the past?

The highest interest rates in Australia’s history happened during the late 1980s when the economy was growing rapidly and prices were going up a lot. In January 1990, the Reserve Bank of Australia set the cash rate at a record high of 17.5% to try to cool down the overheating economy.

During this time, home loan interest rates also increased, with some reaching around 17% in 1989. These high-interest rates made it harder for people to buy homes and spend money, and this caused the economy to slow. This then led to a recession in the early 1990s, which is when the economy stopped growing and began shrinking. After that, the Reserve Bank gradually lowered interest rates to try to help the economy start growing again and reduce the effects of the recession.

So, although the interest rates seem painfully high at the moment, the current cash rate at 3.85% is much lower than the record from the 1990s.

When will interest rates go down?

Hopefully soon, we’ll see changes in interest rates that make life easier for everyone. These changes rely on a lot of different things happening both here and abroad. Main banks, like the RBA in Australia, make these decisions by looking at how the economy is doing now and how they think it will do in the future.

For example, main banks usually lower interest rates when they want to help the economy grow, support jobs, and keep prices stable. If the RBA thinks that prices are stable and the economy needs a boost to encourage people and businesses to borrow and invest more, they might decide to lower the cash rate.

Also, if there are big changes in the world economy or events, like interest rates in other big countries or changes in the prices of important things, the RBA might change interest rates. They do this to help make sure Australia’s economy stays strong and everyone can benefit from it.

What are the effects of rising interest rates?

These affect the economy, businesses, and individuals like you. Some of the notable effects include:

Increased borrowing costs

When interest rates rise, the cost of borrowing money increases. This can make it more expensive for businesses to finance new projects or for you to take out loans for purchasing homes, cars, or other goods. Higher borrowing costs can lead to reduced investments and consumption, slowing economic growth.

Changes in saving and spending behaviour

Higher interest rates make saving more attractive as the returns on deposited funds increase. This may encourage you to save more and spend less, which can decrease aggregate demand and eventually help control inflation.

Increased debt servicing costs

As interest rates rise, you and businesses with existing variable-rate loans face higher debt servicing costs. These are the expenses that you have to pay for borrowed money. These costs usually include interest payments and any fees associated with the loan. This can put financial pressure on borrowers and lead to a higher risk of default, which can negatively affect the overall economy.

Higher mortgage rates

Rising interest rates often result in higher mortgage rates, making it more expensive for you to finance home purchases. This can lead to decreased demand for housing, potentially causing a slowdown in the housing market.

Appreciation of the domestic currency

Higher interest rates can attract foreign investors seeking higher returns, leading to increased demand for the domestic currency. This can result in the appreciation of the currency, making exports more expensive and imports cheaper, potentially impacting the trade balance.

Inflation control

One of the primary reasons central banks raise interest rates is to control inflation. Higher interest rates help reduce spending, borrowing, and overall demand in the economy, which can help slow down the inflation rate and maintain price stability.

What happens to my home loan when interest rates rise?

It all depends on the type of interest rate you have – fixed or variable.

Fixed-rate home loan

If you have a fixed-rate home loan, the interest rate is locked in for a set period, usually one to five years. This means that your repayments will remain the same, regardless of changes in the interest rate during the fixed term. Therefore, if interest rates rise, you will not be affected until your fixed term ends, and it’s time to renegotiate your loan.

Variable-rate home loan

If you have a variable-rate home loan, your interest rate will fluctuate in response to changes in the cash rate or other market conditions. For example, if the Reserve Bank of Australia raises the cash rate, your interest rate and repayments will likely increase. Conversely, your interest rate and repayments will decrease if the cash rate falls.

The exact impact of a rise in interest rates on your variable-rate home loan depends on your loan amount, the remaining term of your loan, and the size of the rate increase.

Even a slight increase in the interest rate can significantly increase your monthly repayments over the life of the loan.

To avoid surprises, it’s a good idea to regularly review your home loan and consider whether refinancing or negotiating with your lender might be necessary to manage the impact of interest rate changes.

Worried about interest rate hikes?

If you have a variable-rate home loan and are concerned about the impact of rising interest rates on your repayments, you might consider refinancing your loan. Refinancing involves taking out a new loan to pay off your existing home loan, often with a lower interest rate or more favourable terms.

Alternatively, it may be worth exploring debt solutions such as debt consolidation or negotiation if you are struggling with debt and high debt servicing costs. Debt consolidation involves combining multiple debts into a single loan, often with a lower interest rate, while debt negotiation involves negotiating with creditors to reduce the amount owed.

If you’re unsure which service is right for you, contact us for more information.