Making sense of the rate cuts, what does it all mean?



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The two recent Reserve Bank (RBA) interest rate rate cuts and subsequent rate changes by lenders around Australia have dominated the media headlines in recent weeks. What does it mean for you?

If you haven’t studied finance, and are currently comparing home loans, you may not be able to make sense of everything. Between recent changes to cash rates, interest rates, serviceability and sensitivity buffers, does the news leave you up the creek without a paddle?

Not necessarily.

From everyday Australians to property developers and business owners, these possibly unfamiliar terms surrounding the rate cuts have sparked a nationwide conversation, and this warrants an explanation of these changes in layman’s terms.

What do the Reserve Bank rate cuts mean, and how will they affect your borrowing power?

It’s probably best to start this from the beginning, because this can get a little complicated. First, let’s talk about the Reserve Bank, also known as the RBA. 

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What is the Reserve Bank of Australia (RBA)?

The RBA is a government owned and operated agency that controls the monetary policy in Australia. The Reserve Bank Board meets eleven times a year, on the first Tuesday of every month, to set a ‘cash rate.’

What is the cash rate and why does the RBA change it?

The RBA is a body corporate with a duty to contribute to the stability of the currency, and economic prosperity of the Australian people. The cash rate is an interest rate that was created as a tool to manage inflation.

The Reserve Bank uses the cash rate to:

1. Determine the interest charged on overnight loans between banks
2. Set a financial benchmark for interest rates in the market, impacting both borrowers and savers
3. Stimulate or dampen consumer spending and inflation, to boost the Australian economy

What is inflation and how does that affect the cash rate?

Inflation is best explained as the percentage change in the price of goods and services that households buy over time. If you’re a visual learner, it may be best to look at the Consumer Price Index (CPI) to get an idea of how the inflation rate has changed in the past century.

The Reserve Bank’s target inflation rate is 2 to 3 per cent, and the current inflation rate as of 24th July 2019 is 1.3 per cent.

As such, the recent cuts have been made to encourage banks and lenders to reduce their current interest rates, so as to boost consumer spending, and increase the overall inflation rate.

What is serviceability, and how do banks calculate it?

You may have also read amongst the RBA rate cut headlines, that a new Australian Prudential Regulation Authority (APRA) ruling has meant banks are changing their home loan serviceability assessments and policies.

Serviceability is a banking term used by lenders to describe the ability of the borrower to meet loan repayments. This is calculated based on the borrower’s income, expenses, loan amount and other monetary commitments to generate an overall figure; the debt service ratio.

The maximum debt service ratio typically ranges between 70-90 per cent, but borrowers need to be aware that lenders can add a sensitivity buffer to the serviceability assessment rate, to ensure borrowers keep up with repayments.

Prior to 5th July 2019, APRA — the independent statutory authority that supervises institutions across banking — enforced a standard 7 per cent interest rate floor on home loan serviceability assessments. This meant that lenders would assess your ability to repay a home loan on an interest rate of 7 per cent, not based the advertised rate of the loan.

However, after the first RBA cash rate cut in June, APRA has removed the standard interest rate floor, and lenders are now able to set their own minimum interest rate floor for use in serviceability assessments, with revised sensitivity buffer of at least 2.5 per cent over the loan’s advertised interest rate.

What impact do interest rate floors and buffers make on borrowers?

Business, finance, saving money, banking, property loan or mortgage concept :  Wood house model, coins, eyeglasses and saving account book or financial statement on office desk table

Let’s see this in action…

Say you’re applying for a $500,000 home loan. The advertised home loan rate is 4.72 per cent, the interest floor rate is 6 per cent and the sensitivity buffer as standard is 2.5 per cent.

The bank will determine your ability to make your loan repayments on either one of two rates:

1. The serviceability / interest rate floor (6 per cent)
2. The advertised loan’s interest rate plus the sensitivity buffer (4.72 + 2.5 = 7.22 per cent)

The key thing to remember here is, you will pay whichever rate is higher.

To make this easier to understand, here are five different examples of how lenders assess your ability to make repayments, determining the amount of money you will be able to borrow.

It’s rare that you will ever pay the interest floor rate advertised by lenders at present, as shown by the example above, and those we have included below.

Lender

Advertised Interest Rate

Sensitivity Buffer Rate

Advertised Rate + Buffer (a)

Interest Rate Floor (b)

The interest rate that will be used to calculate your repayment ability*

CBA

3.45%

2.5%

5.95%

5.75%

5.95%

NAB

3.35%

2.5%

5.85%

5.50%

5.85%

Macquarie

3.24%

2.5%

5.74%

5.30%

5.74%

Westpac

3.48%

2.5%

5.98%

5.75%

5.98%

ANZ

3.38%

2.5%

5.88%

5.50%

5.88%

*Notes: There may be additional fees that apply to your home loan, such as establishment fees, Lenders Mortgage Insurance (LMI) and other charges.

Data accurate as of 24th July 2019

What to look out for…

If you’re currently looking to make the ‘Great Australian Dream’ of owning a house come true, you need to be aware of the complexities of home loans.

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Interest rates, sensitivity buffers, fees, and charges can create an unexpected financial burden if not carefully reviewed.

As with all financial decisions, the “best” home loan for you will depend upon your specific situation, financial circumstances and spending habits. Looking only at interest rates, fees, and charges may not give you the entire picture, so you need to do your research by either speaking directly to the lender or engaging a mortgage broker to help you.

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