Many Australians face the sometimes daunting task of paying back their principal and floating rate home loan towards the end of each month.
Have you ever stopped and wondered how a bank calculates the floating rate?
And when you find that out, can you tell if homeowners are actually getting a fair deal?
Let’s explore that.
How are variable rates determined?
Basically, a bank will choose an interest rate that is higher than the rate it pays on the funds it lends you.
The bank makes money by borrowing at a lower rate and lending you money at a higher rate.
Commercial banks use short-term money markets to finance floating-rate credit products, as opposed to longer-term markets that finance fixed-rate credit.
Banks have many sources of funding across different markets, products and maturities.
However, the most important rate in terms of the banks’ financing costs, according to the Reserve Bank, is what is known as the 3-month bank bill swap rate (BBSW) – this is the rate at which they can issue “bank bills” to wholesale investors.
It is the interest rate at which banks lend one another.
And simply, it is the cost of the banks to issue debt in order to raise their variable loans.
The cost of this promissory note is currently around 2-3 basis points or 0.02 to 0.03 percent.
So the BBSW determines the cost of your adjustable-rate mortgage?
But the commercial banks don’t want to believe that.
The Australian Banking Association (ABA), which represents the major banks, told ABC that the Reserve Bank’s cash rate target, or “cash rate” for short, is the primary reference point banks use to calculate their floating rates .
“The RBA cash rate is not the only input a lender must use to determine their standard floating rate, but it is an important input into the cost of the loan,” noted an ABA spokesman.
“Other costs and inputs that determine the extent to which a change in the RBA cash rate is carried over to banks’ lending rates include the cost of the funds the banks raise, the structure of their deposits and interest rates, and the risk profile of the loans.”
Commonwealth Bank, the largest adjustable rate mortgage loan provider, would not tell you how it sets the cost of its adjustable rate loans.
Price confusion rate
Do you see where this is going?
The central bank says banks pass on the cost of borrowing from the short-term money markets to borrowers (home loan customers).
The costs for this are around 0.03 percent for the banks – an all-time low.
The Australian Banking Association, on the other hand, says banks are using the Reserve Bank’s cash rate target.
So what is the RBA’s cash rate goal?
Well it really is nothing more than a price signal that the RBA uses to move the BBSW higher or lower.
It is currently 0.1 percent.
But that’s 0.07 percentage points above the BBSW.
To be fair, the BBSW is recognized as a factor in the total cost of an adjustable rate loan to a bank.
However, the uncomfortable truth is that it is the biggest factor.
So the banks claim that one of the costs of raising the funds for your adjustable rate home loan is higher than it actually is.
The pandemic is behind the confusion
Velocity Trade’s bank analyst Brett Le Mesurier points out that prior to the pandemic, the BBSW was largely in line with the Reserve Bank’s cash rate target (the two were highly correlated).
Printing large amounts of money has reduced the value of cash to practically zero.
So while the Reserve Bank’s cash rate target is 0.1 percent, the market rates “Cash” (BBSW) at just 0.03 percent.
“So it was easier for [the banks] to explain to their retail customer base that the standard floating rate moved because the cash rate changed, but the bigger truth is that the BBSW moved, “he said.
He said “of course” banks could cut the cost of their adjustable rate mortgage products, but logistically they just couldn’t handle the resulting surge in demand.
“You don’t have a whole bunch of people turning their thumbs,” said Mr Le Mesurier.
In addition, investors would bear the costs of this with lower investment returns – because the bank would make less money overall.
Are you paying too much
But there is another inconsistency.
There is a significant difference between what the average large bank customer pays for an existing floating rate loan and what is offered to a new home loan customer.
Latest data from the Reserve Bank shows that the average owner-occupier mortgage rate for existing customers is 2.92 percent, while the average rate for new customers is 2.42 percent – that’s a difference of half a percentage point, or 0.5 percent.
Existing owner-occupier mortgages
New owner-occupier mortgages
It makes a big difference to your monthly mortgage repayments, “said Sally Tindall, Research Director at RateCity.
“For example, a $ 500,000 home loan with a term of 30 years at 2.92 percent interest – you’re paying just over $ 2,000 a month.”
“A new customer, however, would pay $ 132 less a month.”
Up to the customer
Commercial banks operate on a marketplace.
They adjust the prices of their products according to supply and demand.
Reserve Bank Governor Philip Lowe has encouraged home loan customers to shop for the best deal.
Ms. Tindall said the hard truth is that too few bank customers ever bother looking for a better deal.
“Some banks rely on the complacency of [their customers] so as not to rummage around, “she said.
The process of switching home loans between banks can take up to 4 weeks and requires some paperwork and phone calls.
The evidence shows that with a little effort, many mortgage holders could save hundreds of dollars on their adjustable rate mortgage.
That’s a significant monthly saving.
The extra saving is critical to the economy now, too, as much of the shopping that is currently driving the economy is made possible by households breaking open their piggy banks.