What should you do with the rate cut?

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It's the rate relief news many Australians have been waiting for, as the Reserve Bank of Australia (RBA) cut interest rates by 50 basis points on Tuesday. But it will count for little if the banks fail to pass the cut on, and now millions of Australians are waiting to see what they will do.

Financial commentators believe it's unlikely that all lenders will pass on all the savings.

Damian Smith, chief executive of RateCity, said the signals from the big four banks suggest that they will try to hold on to part of the rate cut.

"Of the 50 basis point cash rate reduction from the RBA since November, the big four banks have only passed on around 40 basis points to variable rate home loan customers," he said.

Business analyst Peter Switzer said there is no obligation for the banks to reduce rates in line with the RBA's move.

"It's going to be in the hands of the banks, how much they pass on. We'd love to see them pass the whole lot on, but I reckon we'll see something like a 35 basis points," he said.

John Symonds, founder of Aussie Home Loans agreed: "I think the reality is the banks will probably keep 10 basis points, maybe eight to 10, which would leave 40 basis points to go to much needed household savings".

If the banks do pass on at least some of the rate cuts, about 2.5 million Australian households with variable mortgages will find that their repayments are automatically lower by the end of the month. The big decision is what to do with any extra cash this change generates.

For homeowners with a $300,000 home loan, for instance, and paying a rate of 6.64 percent before the RBA decision their monthly repayments would have been about $1924 (based on a loan term of 30 years). If a lender passes on the full 0.50 percent reduction, those borrowers would now be paying 6.14 percent, and monthly repayments would go down to $1826, a saving of $98 per month.

But by keeping repayments at the previous level of $1924, the extra $98 goes straight into reducing the loan principal, and so the amount of interest being charged goes down. The effect of this would be to reduce interest payments over the life of the loan by more than $54,500 and shave almost 4 years from the life of the loan itself. To see how much you could save on your home loan by maintaining higher repayments, try using RateCity's mortgage calculator.

It may seem surprising that a relatively small amount of money – literally, just over $3 per day – can have such a big impact, according to Smith.

"But because you are reducing the principal of the loan faster, you reduce the "base" of which interest is charged. Extra repayments are like a fuel additive or your engine – they can absolutely increase your speed," he said.

Some homeowners will need the extra money to deal with other costs in their life, so reducing repayments is understandable, Smith added.

"But if the big issue for you is that you can't afford to keep repayments at the previous level because you were already struggling with cash flow, then the answer is to refinance into a lower-rate loan."

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