Sunday, December 5

Inflation and Interest Rates Explained

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The Reserve Bank of Australia (RBA) determines the official interest rate across the country; it is set each month of the year excluding January. Both this official interest rate and also the inflation rate are reported regularly through a variety of media points, from traditional information outlets like news reports to social media. It can be easy to confuse the two terms, but both have different roles and impact – particularly when it comes to mortgage rates. Let’s look at what you need to know about these important financial terms before you arrange to meet up with your loan broker.

Inflation Rates

In a nutshell, this is the rate at which prices increase over time. As prices increase, this results in a decrease in what money can buy; therefore, there is a fall in the purchasing power of the dollar.

The RBA regularly produces infographics showing the rise and fall of inflation in the country, and for the past 3 years this has come under the target of 2% to 3%. What this means is that the annual consumer price inflation stays between 2-3% and is measured by the percentage change in the Consumer Price Index.

The Consumer Price Index captures the changes in prices for services and goods that households buy, and this Index is produced by the Australian Bureau of Statistics. The CPI measures the rate of price changes – not the price level – so if the price index of milk is 180 and the price index of eggs are 140, this doesn’t mean eggs are cheaper than milk. It just means the price of milk has increased more than the price of eggs from one point in time.

Inflation Targets

This target gives structure and a framework in which central banks work to guide and set out their policy decisions, as well as make sure there is accountability in the central bank’s management of the economy. It is not just Australia that adopted an inflation target back in the 1990s; various central banks around the globe did the same. The RBA uses the inflation target to enable it to achieve its key goals of full employment, stable prices, and prosperity for the Australian populace. Stable prices (which mean stable and low inflation) are a contributing factor in sustainable economic growth.

 

Inflation vs Interest Rates | LaptrinhX

What if Inflation Rates are too High?

If the cost of living is increasing more quickly than your income, then you will not be able to afford to buy the goods and services normally purchased. The push for higher wages in turn impacts on businesses, who may have to increase their costs or reduce their workforce. Returns on any investments can be lower and therefore affect real interest paid by borrowers to lenders.

To take one example – if inflation is higher than expected when a loan has been agreed, then the lender won’t get back as much as they planned due to inflation reducing the buying power of the interest earnings they do receive. This could mean lenders are not prepared to give loans and might impact on the range of loans available that suit your needs.

What Effect Does this Have on the Interest Rate?

The official interest rate in Australia is the cash rate and this is determined by the RBA. When you take out a home loan (or any loan) you are expected to pay back the sum of money borrowed plus interest over a fixed period of time. Shorter loan terms normally mean higher repayments but less interest in the long run, whereas longer terms can cost you more in interest but have a lower monthly repayment rate.

Normally, this is worked out by dividing the interest rate by the number of payments in one year and multiplying this by the balance of the loan. This will give you how much interest you would pay in the first month but if the interest rates increase, then loan repayments can increase.

If you go for a variable home loan, the interest rates will be affected by changes in inflation because variable interest rates will fluctuate (up or down) depending on the cash rate. Changes in inflation would not impact on repayments to a fixed term loan because you would have agreed how much interest and the amount of repayments in advance.

Interest rates have steadily fallen over the past 20 years and currently are held at a record low of 0.1%. This is a scenario that is being played out across the globe as the world economy struggles to rebound after the impact of the pandemic. If you are looking to revisit your current home loan or wanting to finance new or current business needs, get in touch with a home or business mortgage broker today.

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