Just what is going to happen with inflation and interest rates?
I asked HoLo co-founder & lover of all things finance, Justin Dickinson (aka JD), for his views on what homeowners should expect and - more importantly - do in uncertain times.
Hey, JD! It seems like every time inflation edges upwards there’s an economist (or three) suggesting the RBA may have to raise rates. Why is that?
JD: Hey Richard. Put simply, inflation measures how much prices for everyday things like food, clothing and housing increase over time.
Another way to think of inflation is it measures how much our day-to-day living expenses are growing.The Reserve Bank of Australia (RBA) keeps an eye on inflation to keep the economy stable and one of their key tools to manage it is interest rates.
OK, that sounds sensible, but why raise rates?
JD: Interest rates are closely linked to inflation because (very broadly) they help to control the way that we all spend our money and how fast prices can rise. When inflation goes up, the RBA might raise interest rates to discourage us from spending, which should then slow down how quickly prices are rising. When inflation goes down, the RBA might lower interest rates to encourage us to spend a little more.
So rates are a bit like a lever: push it one way for one effect on the economy, or the other for the opposite.
JD: That’s actually a really good way to think about it, yes. The RBA likes inflation to be between 2-3% each year because it suggests that everything in the economy is balanced nicely. But generally, if inflation is higher than 3%, the RBA will push up interest rates to slow down the economy, or pull down interest rates to speed up the economy if inflation is lower than 2%.
The RBA does this by changing what is known as the ‘Cash Rate’.
And there’s a knock-on effect to the interest rates at our banks?
JD: Yep - exactly. The Cash Rate is the interest rate that Australian Banks pay to each other when they borrow overnight (and just remember that a LOT of money swaps between all banks every single day).
So when the RBA changes the cash rate it impacts the cost of money for our banks, which they pass onto to us through their interest rates.
So why is that such a big deal for those of us with home loans?
JD: If the cost of our home loans increases, the theory is that we will spend less on other things because more of our regular income is needed to repay our mortgages. That’s how home loans and inflation are linked.
On the flip side, an interest rate decrease means we need less of our income to pay a lower loan repayment, so we have more to spend on anything else that we want.
So if someone has a variable interest rate home loan, their regular loan repayment will pretty-much change each time there is a change to the RBA Cash Rate - up OR down. But If they have a fixed interest rate home loan, their regular loan repayment won’t change, despite there being a change to the RBA Cash Rate, because they locked their rate in for an agreed amount of time. Their repayment will only change when the fixed interest rate period finishes.
When Inflation goes up, interest rates go up. When inflation goes down, interest rates go down.
JD: Pretty much; yes.
OK, great. So after a series of interest rises, inflation should gradually come down followed immediately by home loan rates, easing everyone’s cost of living. Sounds simple enough.
JD: That does sound nice and simple, however it is a little more complex than that.
Just because inflation has come down, doesn’t mean interest rates will follow straight away. Sorry to tell you that.
Interest rate reductions may take a little longer because it may take longer for the inflation to get back to that level the RBA likes. This is due to other factors, such as wages going up, meaning we’ve still got some spare cash to splash. Generally, when inflation goes up, we ask, and often get, pay rises to help us keep up with rising costs. And businesses will then pass the cost of those pay rises on in higher prices. So that last bit of inflation can be ‘stubborn’ (as economists like to say).
Just remember, costs (or prices) generally don’t go down, they just don’t go up as fast.
Err…say what?
JD: Ha! I know, right? Another reason why it isn’t that simple, is because higher interest rates have a negative impact on two-thirds of Australians and a positive impact on a third of Australians.
One third of us own a home & have a mortgage; one third of us rent, plus their landlord generally has a mortgage. The last third own a home without a mortgage, meaning the interest rates rises give them more interest on their savings, meaning they spend more.
Ok. So where does that leave us?
JD: Well, it’s because of these last two reasons that the RBA, in our opinion, will often be more cautious about rate decisions when they are considering changing direction. That is, when they are thinking about changing from increasing to decreasing or vice versa.
Hmmm… complicates things a bit. What does this mean for those of us with home loans then?
JD: Actually, it just reinforces the guidance HoLo has always given:
Have a plan for finances, such as a household budget and review it regularly. Circumstances can change so make sure there is some flexibility in there too.
Put your savings to work by using an offset account to reduce the interest you pay on your home loan, to help pay it off sooner.
Consider whether having a set loan repayment for a period would work for you. Changing to a fixed interest rate for some or all of your loan can be simple and mean any changes to interest rates wouldn’t impact you for that period.
Keep an eye on things happening in finance & the economy, which will help you avoid the dreaded apathy that many people fall into when it comes to their household finances.
Good advice! There’s another blog on that which shares 7 tips to pay down your home loan sooner. Thanks JD! Anything else you’d recommend?
JD: If anyone has questions or just wants a check-in chat about their home loan, then schedule a call with one of the team below:
Justin Dickinson was speaking with HoLo Head of Marketing, Richard Woof. The information provided here is not legal, taxation or financial planning advice. It has been prepared without considering your specific needs, objectives and personal financial situation. Before acting on this information, we recommend that you consider carefully if it is appropriate for your needs, objectives and personal financial situation.
If you’d like to know more, book an appointment or contact us.