For most people, interest rates can be confusing. The Reserve Bank of Australia (RBA) is tasked with the responsibility of setting interest rates. It does this at monthly board meetings by determining the cash rate. The cash rate is the price the big retail banks pay to borrow money in the overnight cash markets.

This is part of a mechanism the Reserve Bank uses to control the level of cash or liquidity in the banking system. Doing so directly impacts the rate of interest charged by banks, not just on home loans but also on every product they sell.

This is a critical lever the Reserve Bank uses to regulate economic activity. In a situation where the economy is slowing, the RBA can lower the cash rate. This increases liquidity throughout the banking system and encourages the big banks to reduce rates.

If the economy is trading too strongly, often indicated by a sharp upturn in property prices or a jump in the inflation rate, the RBA can use the cash rate to reduce liquidity, increase interest rates, and slow activity.

Many Australians have taken out substantial home loans in recent years, believing record low interest rates would remain for some time. Therefore, even a small rate hike can significantly impact the cost of their mortgage.

The pandemic encouraged saving, with an estimated additional $50 billion being contributed to home loans during this time. On average, home buyers were then 45 months ahead on their repayments. While this was good news, it would halt the impact of any RBA rate rise as home buyers could effectively use the equity built up in their home loans to offset the higher bank charges.

Tough competition amongst the big banks can put significant downward pressure on all rates, including home loans. This is expected to continue as innovation and technology reduce the cost of lending.

The RBA’s integral role in regulating economic activity and the impact each of its decisions has on our own finances can be quite confusing. However, understanding a little about the mechanisms behind each cash rate adjustment can ease uncertainty about future interest rate fluctuations and help us all feel more comfortable in our own financial positions.