For those of us with a mortgage, the first Tuesday of every month holds special significance.  At 2.00pm (AEST) on that day each month, the RBA Board release their decision regarding any potential change to the Cash Rate.  If the decision is “hold” we all breath a collective sigh of relief.  If the decision is to increase the Cash Rate, then we take it as a given that our lender will also increase our mortgage interest rate by at least the same amount.

But why is that?  Why does a change in the official Cash Rate effect us all so personally?

Essentially the Cash Rate (currently 4.75%) is the price at which financial institutions such as banks, credit unions and building societies can buy/borrow money from each other in a virtual shopping centre called the Short Term Money Market.  The RBA are the regulator of this market  and they manipulate the price of money within this market place by injecting or withdrawing funds. The traditional laws of supply and demand apply.

So when the RBA decides that the new cash rate is 4.75%, they don’t actually dictate the interest rate – but they do control the flow of cash in the market to make the price of money roughly 4.75%.  To put the current Cash Rate of 4.75% into perspective, most lenders are now charging us around 7.00% for a variable rate home loan and the 2.25% difference (their margin) is used to fund their operating costs.  Whatever is left over after that is their profit.

Since early 2008, Australian lenders have lifted their home loan rates approximately 1.20% in total, above the usual cash rate movements. This is a departure from what was traditionally considered to be “normal” behaviour, given lenders only ever moved their interest rates in line with the RBA Cash Rate.

Interestingly, due to a shortfall of available funds in Australia, around half of the money that has been lent out to us mortgage holders has been sourced from a global Short Term Money Market that is generally known as the “wholesale” or “securitisation” market.  Due mainly to the Global Financial Crisis, the price of this wholesale money had been quite high until recently. This is the main reason why Australian lenders have increased their interest rates beyond the cash rate for the last two years.

The good news for 2011 is that the cost of this wholesale funding is getting cheaper as the effects of the GFC subside.  Also, these lower funding costs are enabling other lenders to enter or return to the market to undercut the existing lenders.  In the absence of a branch network, the main avenue for these new lenders to get their product to market is via finance brokers such as myself.  As a result of this, the consumer may well start to see a mortgage price war as the banks try to maintain their massive market share gained during the uncertainty of the GFC. I think that has started this week.

It’s good news for borrowers if increased competition drives the lenders margins and interest rates down.

Regards,