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How the Cash Rate Affects the Personal Loan Interest Rates
●March 23, 2021●3 minute read
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Personal loan interest rates often fluctuate, but what causes this? Does the cash rate affect the personal loan interest rates? Firstly, it is important to understand what the cash rate is and why this is relevant when discussing interest rates.
What is the cash rate?
The cash rate is the interest rate at which banks pay to borrow money from other financial lending institutions. The cash rate is set by the Reserve Bank of Australia (RBA), the central bank of Australia that derives its power from the Reserve Bank Act 1959, and is reviewed on the first Tuesday of every month. They can choose to either keep the cash rate the same or change slightly to represent and maintain the current economy. The cash rate recently dropped from 0.25% to 0.1% because of the current economic state due to the coronavirus pandemic.
How does this affect personal loan interest rates?
Since the cash rate dictates how much interest banks pay to borrow money, this cost is often passed down and reflected in interest rates. However, this is not the only factor that has an influence on interest rates. Some of these factors include but are not limited to the following.
Cost of funds
Banks and other lenders largely make their money through their costs of funds and net interest spread. The interest rates banks/lenders are offering on their personal loans will be higher than the rate of interest they pay to obtain the funds. They source their cost of funds from:
- Deposits and transactions
- Domestic ‘open market’ (influenced by the RBA and thereby the cash rate)
- International ‘open market’
Competition in the financial industry
If banks and lenders are offering competitive interest rates, at most times, the other banks and lenders will follow. This is to stay competitive, retain their current customers and attract new customers.
Most banks have their own strategy to achieve market penetration, market and product development and diversification. Their strategic choices may have an influence on the interest rates they offer.
Rate of return required for equity holders
This is the money investors require for investing in the banks as compensation for the risk involved in holding this stock. Depending on the rate of return their investors require will dictate how competitive they can be with their interest rates.
What does this mean for you?
If you are considering taking out a personal loan, now is likely the best time to do so. Interest rates are extremely low due to the coronavirus pandemic that has impacted the economy. However, it is important to consider the terms of your loan in reference to interest rates. If you choose to get a loan with a variable interest rate over a term of 5 years, it is likely that the interest rate may go up when the economy recovers. It is important to consider whether you can still afford to make your loan repayments if the interest rate changes and you are required to pay interest at a higher rate.
It is clear that the cash rate has some effect on personal loan interest rates. However, personal loan interest rates are highly complex and are influenced by more than one factor.
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Written by Jacaranda Team