The Reserve Bank of Australia has raised the official cash rate for the first time in nearly 12 years, making life even more expensive for many Australians who own a home.
Tuesday’s RBA announcement took the official cash rate 25 basis points higher to 0.35%, the first interest rate rise since November 2010.
With surging inflation already putting pressure on households through higher costs at the checkout, many are wondering why the RBA would also move to increase mortgage repayments with a higher cash rate.
It sounds counterintuitive, but there’s method to the madness.
We’ve unpacked some of your most common interest rate questions below.
Why are interest rates rising?
The RBA has three major goals: price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve this, the RBA has an inflation target of between 2% to 3% on average, over time, and the cash rate is the main tool used to manage inflation.
Last week, inflation data by the Australian Bureau of Statistics confirmed the Consumer Price Index (also known as headline inflation) – the change in the cost of items households usually buy – has shot up 5.1% in the past year.
The trimmed mean, the RBA’s preferred indicator of underlying inflation, also reached 3.7% – well above the RBA’s 2% to 3% target range.
Prolonged periods of high inflation can also lead to increased unemployment as consumers stop spending and businesses look to cut costs, so the RBA has tightened its monetary policy and increased the cash rate.
What happens when interest rates rise?
The goal of a cash rate rise is to dampen inflation by cooling spending activity.
When the cash rate is increased the cost of borrowing for lenders is higher, and that cost is passed on to borrowers in the form of interest rates.
And when costs go up, households tend to tighten the purse strings a bit more. It means borrowers will have less money for non-essential items because more of their money is going towards keeping a roof over their head.
It comes as many Australians also spend more on non-discretionary items like food and petrol.
How will a higher interest rate impact me?
For homebuyers, increased interest rates mean their borrowing capacity is now less than it was before interest rates started to increase.
So if house prices stay where they are (or increase) they’ll need to aim for something a bit cheaper or save for longer.
Lenders will have to factor in the higher interest rate plus any likely subsequent rate rises (more on that later) before determining how much they’re willing to lend.
For homeowners, including those with personal loans to pay for renovations, it means they’ll pay more interest on the loan (or loans) they currently have.
And for anyone who purchased their home after November 2010 that might come as a shock because that’s the last time the RBA increased the cash rate, so their interest rates have only gone south since.
How quickly will interest rates rise?
That depends on which economist you ask, but the general consensus is for several small increases in the months ahead to take the cash rate between 1% and 1.5% by the end of the year.
“Generally we see a series of interest rate rises as the RBA attempts to slow down the economy and keep inflation between its 2% and 3% target band, or we see a series of interest rate cuts to move inflation back into its target band and accelerate economic growth,” said Belinda Allen, senior economist at the Commonwealth Bank.
“Every economy has what we call a neutral interest rate, one that isn’t putting the brake on an economy and one where it isn’t accelerating economic growth.
“Generally central banks do a series of rate changes to move interest rates back above or below neutral depending on the circumstances.”
CBA currently estimates neutral to be 1.25% and expects rates will gradually increase to that point by the first quarter of 2023.
Which leads us to the next question…
How high will interest rates go?
Again, predictions vary from economist to economist, bank to bank.
CBA’s forecast is a best-case scenario for homeowners when compared to the predictions of the other big four banks.
NAB is forecasting the cash rate will reach 2.5% by August 2024.
Westpac economists think the cash rate will reach 2% by May 2023.
And ANZ predicts it will shoot to 2.25% over the next 12 months.
Do house prices drop when interest rates rise?
Not historically, according to PropTrack economist Paul Ryan.
“What typically happens when interest rates increase is that housing prices continue to increase, that’s despite the fact that interest rate increases definitely weigh on housing price growth,” Mr Ryan said.
“And the reason for that is interest rate rises don’t happen in a vacuum, interest rates are increased when the economy is performing really strongly and other things that influence housing prices tend to be positive, and the main one there is things like income growth.”
Mr Ryan says the last time we saw property prices fall off the back of increased interest rates was 1994.
But other hiking cycles in 1999, 2002 and 2009 saw prices either stay flat or increase slightly.
That being said, RBA modelling suggests house prices could fall as much at 15% over the next two years if the cash rate increases to 2%.
It sounds like a lot, but house prices did increase 23% nationally over 2021.
Why you shouldn’t necessarily be worried
While higher interest rates will ultimately raise costs for many homeowners, Ms Allen said higher interest rates typically signal the economy is doing well.
“The labour market is close to full employment, with the unemployment rate at 4% and a record high participation rate,” she said.
“In short the economy is in the right position to deal with higher interest rates and together with inflation accelerating, and wages growth rising, the RBA will start to move monetary policy back towards a neutral setting.”
Ms Allen says there’s lots of evidence that most homeowners are well ahead on mortgage repayments and have sizeable buffers in their offsets.
“Plus households saved an extra $265 billion over the pandemic that normally wouldn’t have occurred due to income growth outpacing spending,” she said.
“In short households are in a good position.
“But this is a general view and there will be some households that will find higher interest rates more of a challenge than others.”
DISCLAIMER: The information contained in this article is correct at the time of publishing and is subject to change. It is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, Smartline recommends that you consider whether it is appropriate for your circumstances. Smartline recommends that you seek independent legal, financial, and taxation advice before acting on any information in this article.