27 September 2023

The variables in variable rates

Start the conversation

David Taylor* says the big banks could drop their variable rates much lower, and explains how rates are calculated.

Many Australians, towards the end of every month, face the sometimes daunting task of making repayments on their principal and interest variable rate home loan.

Have you ever stopped and asked yourself how a bank works out what that variable rate should be?

And once you’ve worked that out, can you determine if homeowners are actually getting a fair deal?

Let’s explore that.

How are variable rates determined?

At a very basic level, a bank will choose an interest rate higher than the interest rate it is paying on the funds it’s borrowing to lend to you.

The bank makes money by borrowing at a lower rate and lending you money at a higher rate.

To fund variable rate loan products, commercial banks use short-term money markets – as opposed to longer-term markets that fund fixed-rate loans.

Banks have many sources of funding spanning various markets, products and maturities.

The most important rate, though, in terms of bank funding costs, according to the Reserve Bank, is what’s known as the three-month bank bill swap rate (BBSW) – this is the rate at which they can issue ‘bank bills’ to wholesale investors.

It’s the rate at which banks lend to one another.

And simply, it’s the cost for the banks of issuing IOUs to source their variable loans.

The cost of this IOU is currently around 2-3 basis points, or 0.02 to 0.03 per cent.

So the BBSW determines the cost of your variable rate mortgage then?

Well, yes.

But that’s not what the commercial banks would have you believe.

The Australian Banking Association (ABA), which represents the major banks, told the ABC the Reserve Bank’s cash rate target, or “cash rate” for short, is the major reference point banks use to work out their variable interest rates.

“The RBA cash rate is not the only input a lender needs to use in determining their standard variable rates, however it is an important input into the cost of the loan,” an ABA spokesperson noted.

“Other costs and inputs which determine the degree to which a change in the RBA cash rate is passed through to banks’ lending rates include the cost of funds the banks source, the structure of their deposits and interest rates, and the risk profile of the lending.”

The Commonwealth Bank, the largest provider of variable rate loans to mortgagors, declined to say how it determines the cost of its variable rate loans.

Rate cost confusion

Do you see where this is heading?

The Reserve Bank says the banks pass on the cost of borrowing money from short-term money markets to borrowers (home loan customers).

The cost of that is roughly 0.03 per cent for the banks — an all-time low.

The Australian Banking Association, on the other hand, says the banks use the Reserve Bank’s cash rate target.

So, what is the RBA’s cash rate target?

Well, it’s really nothing more than a pricing signal the RBA uses to move the BBSW higher or lower.

It’s 0.1 per cent at present.

But that’s 0.07 percentage points above the BBSW.

To be fair, the BBSW is recognised as being one factor in the total cost of a variable rate loan for a bank.

The awkward truth though is that it’s the largest factor.

So the banks are claiming one of the costs of sourcing the funds for your variable rate home loan is higher than what it actually is.

The pandemic is behind the confusion

Banking analyst Brett Le Mesurier from Velocity Trade points out that, pre-pandemic, the BBSW largely moved in line with the Reserve Bank’s cash rate target (the two were highly correlated).

Large amounts of money printing has lowered the value of cash to basically nothing.

So while the Reserve Bank’s cash rate target sits at 0.1 per cent, the market is valuing “cash” (BBSW) at just 0.03 per cent.

“So it was easier for [the banks] to explain to their retail customer base that the standard variable rate was moving because the cash rate was moving but the greater truth is that it was because the BBSW was moving,” he said.

He said “of course” the banks could lower the cost of their variable rate mortgage products but, logistically, they simply couldn’t handle the resulting increase in demand.

“They don’t have a whole bunch of people twiddling their thumbs,” Mr Le Mesurier pointed out.

In addition, investors would wear the cost of this with lower investment returns – because the bank would make less money overall.

Are you paying too much?

But there’s one more inconsistency.

There’s quite a sizeable difference between what the average big bank customer pays for an existing variable rate loan and what is offered to a new home loan customer.

The latest data from the Reserve Bank show the average owner-occupier mortgage rate for existing customers is 2.92 per cent, while the average rate for new customers is 2.42 per cent – that’s a difference of half a percentage point or 0.5 per cent.

It makes a huge difference to your monthly mortgage repayments,” RateCity Research Director Sally Tindall said.

“For example, on a $500,000, 30-year home loan, at a rate of 2.92 per cent – you’d be paying just over $2,000 a month.”

“A new customer, on the other hand, would be paying $132 less a month.”

Down to the customer

Commercial banks operate in a marketplace.

They will adjust the pricing of their products based on supply and demand.

Reserve Bank governor Philip Lowe has encouraged home loan customers to shop around to get the best deal.

Ms Tindall said the hard truth is too few bank customers ever make the effort of searching for a better deal.

“Some banks rely on the complacency of [their customers] to not shop around,” she said.

The process of switching home loans between banks can take up to 4 weeks and involves some paperwork and phone calls.

The evidence shows that though, with a bit of effort, many mortgagors could be saving hundreds of dollars on their variable rate mortgage.

That’s a significant monthly saving.

The extra saving is crucial for the economy now too, because much of the shopping that’s currently helping drive the economy forward is being made possible by households cracking open their piggy banks.

*David Taylor is a business reporter for the ABC’s Audio Current Affairs programs. He can be contacted on Twitter at @DaveTaylorNews.

This article first appeared at abc.net.au

Start the conversation

Be among the first to get all the Public Sector and Defence news and views that matter.

Subscribe now and receive the latest news, delivered free to your inbox.

By submitting your email address you are agreeing to Region Group's terms and conditions and privacy policy.