Interest rates explained: how they affect you

There has been endless coverage of interest rates since late 2011, when the Reserve Bank announced its first cut in 31 months, but what does a rise or fall in the national cash rate really mean for consumers?

In a broad sense, the Reserve Bank will lower the interest rate in order to stimulate growth. As an interest rate is essentially the cost of money, a low interest rate will reduce the cost of borrowing for consumers. A possible outcome is that consumers will have greater access to funds and will therefore increase their spending, which stimulates the economy.

Likewise, those with existing loans, particularly property-related loans, will be paying slightly less on their mortgage or other forms of credit. Conversely, changes to interest rates also affect how much money is worth in the long-term. For instance, those with term deposits or investments will need to know their money will not depreciate in value over time, due to cost of living pressures.

It is interesting to note, however that while Reserve Bank cash rate decisions would traditionally have guaranteed a corresponding fall in interest rates, this is less certain lately due to wider issues within the economy that are affecting lending institutions. The decision to pass on these rate cuts is now a far more delineated process between the RBA and banks and is being influenced by issues such as wholesale funding costs.

While it can seem difficult to find direct linkages between decisions from the nation's central bank and the everyday life of the average Australian, these changes will in fact have significant, long-term impact on household finances of any consumer accessing finance, which is almost all of us.

In real terms, interest rates affect:

Mortgages

The affect of an interest rate change on a property or other asset loan will be determined by whether the loan was entered into at a fixed or variable rate. There are of course advantages and disadvantages associated with both types of interest, and the stability of the wider economy will often influence the decision to enter a fixed rate mortgage.

If the economy is doing well, for instance, and consumer spending is up this increases the likelihood the Reserve Bank will increase rates therefore consumers entering into a mortgage at this time will be more likely to select this type of interest.

Of course the opposite is true if economic growth is sluggish. During slow growth periods, the RBA will reduce rates to stimulate spending and consumers will therefore be more inclined to enter into a variable mortgage. Variable loan holders enjoy the benefits of rate reductions, as well as the strain of a rate increase and for a loan with a life of around 20 years or more this can be a difficult decision for borrowers.

Credit cards

Around 15 million Australians own a credit card, with an average rate of anywhere between five and 25 per cent interest charged on balance owing. Credit card interest can fluctuate based on the type of purchase made and a consumer's credit history will impact the rate they are offered initially. Not all credit cards are subject to changes in the national cash rate, as it will depend on the individual credit provider and, as with a mortgage whether the interest rate is fixed or variable.

Savings

Interest rates are one of the key incentives to save, as of course this builds on the value of your money over time. Unfortunately, cuts to the national interest rate will inevitably affect how much money consumers are able to accrue through term deposits and standard savings accounts.

Investments

Bond holders will also lose out of an interest rate is reduced, as it means the value of their long-term investment is diminished affecting the return on investment.

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