It’s all about the rates.
With so many current discussions about fixed rates, it is no surprise that there is a great deal of misunderstanding regarding how Banks and lenders arrive at rates; We thought it would be useful to share some brief facts in response.
The RBA’s overnight cash rate is the most basic form of interest rate. It’s a very short-term loan. The overgeneralized explanation is that if a bank has too much money at the end of the day, it can give it to the RBA and get paid the cash rate for that money, or pay the rate if it has insufficient funds. But that doesn’t imply they’re raising adequate capital – they can’t just decide to increase their home loan portfolio by a billion dollars and then borrow from the RBA at that rate.
The most common ways to develop their loan book are (1) customer deposits (term deposits and daily accounts) or (2) borrowing on the wholesale market from institutional investors.
Banks obviously have their own term deposit and bank account rates, so this is the most popular approach, but most banks can only fund a fraction of their loan book in this manner. Because they don’t provide deposit services, some cannot fund any at all.
A wholesale market… I’ll try to keep things as basic as possible since this is a lot more complicated than I can describe in one paragraph…
Let’s assume you’re a firm applying for a bank loan. If you’re a low-risk candidate, you’ll be offered a better rate; if you’re a high-risk one, the amount will be higher. The same goes for banks and brokers on the wholesale market… It’s safer for me to lend money to an institution rather than someone with little documentation if I’m an institutional investor. As a result, those two lenders offer different rates for their funds. They then add a margin on top of the wholesale cash, which results in your retail borrower paying a higher interest rate.
As a lender, you now want to provide your borrowers with variable and fixed rates. To manage the risk, you need to roughly match the loans you give out with the bulk of your wholesale funding sources. Simply said, if a bank has $1 billion in fixed-rate liabilities on its balance sheet, it wants to keep $1 billion locked away as wholesale 3-year money.
The perfect real-world illustration of what happens when banks/lenders botch this up is RAMS Home Loans. In a nutshell, they offered long-term fixed rates to their borrowers but didn’t bother to lock away their financing costs. The market turned against them, and the result was that they were getting less interest than they paid, causing them to go bankrupt.
So, how does this work in practice? Every day/week/month (depending on the size of the institution and how much they’re lending), a bank or lender will look at what they’ve written and go to the wholesale market to secure their cost of funds. If they wrote $500 billion in three-year fixed rates and $200 billion in five-year fixed rates, they’ll lock those amounts and terms on the market to prevent any future RAM situations.
Finally, whatever their variable rate deal is, it will be mostly utilized on the wholesale market for short-term borrowing.
The rate is changed based on the credit risk of the borrower (I.e., the bank/lender), but you have a general idea – this is wholesale market pricing without any frills.
This is why fixed-rate home loans have risen so dramatically. The market truly is 2.5% to 3% above the short-term (variable) rate, as advertised.
So, why should we be concerned? Macroeconomics lesson… However, inflation is the woolly mammoth in the room. The US just set a 40-year record for price increases and it appears that we’re next (hopefully not as severely).
As for politics, it’s highly unlikely that Labor or the Liberal Party will have a better chance of controlling it than one of the others. It’s a worldwide issue, and we’re all in it together!
It never hurts to ask the question, so get in touch to review your options.