Finance 101: understanding interest rates and why they matter

Learn how interest rates influence loans, savings and investments, and find out why staying informed about interest rates can empower your financial decisions.

4 min read

A man playfully dips a woman backward in a dance pose in a bright, modern kitchen. She wears a red t-shirt, and he is in a light blue shirt over a white t-shirt with blue jeans.

In this series, we break down finance jargon plain and simple. Here, we dive into the world of interest rates – those small numbers with a big impact on our lives. Whether you're planning to buy your dream home, save for a brighter future or simply manage your daily finances, interest rates play a key role. Here’s why they matter when planning your financial future.

What are interest rates?

Interest rates are essentially the cost of borrowing money or the reward for saving it. When you take out a loan, whether it's for a car, home or business, you'll pay back the amount borrowed plus an additional percentage per year, known as the interest rate. Conversely, when you save money in a high-interest bank account, an interest rate determines the extra money you earn on your savings.

What is the RBA and how do they control interest rates?

The Reserve Bank of Australia (RBA) is Australia’s independent central bank. The bank conducts the nation’s monetary policy and issues its currency. The RBA determines the cash rate target, which is a base rate that impacts other interest rates such as mortgage or deposit rates.

Why does the RBA raise or lower rates?

The RBA adjusts the cash rate target to preserve full employment and the economic prosperity and welfare of Australia. The RBA might raise rates to curb inflation when the economy is growing too quickly, as higher rates can help cool down consumer spending and borrowing or investments. On the other hand, the RBA may lower rates to stimulate economic activity during a slowdown. Lower rates make borrowing cheaper and encourage spending and investment, which can help boost employment and economic growth. By adjusting interest rates, the RBA aims to keep inflation within a target range of 2-3% and support the overall health of the Australian economy.

How do banks set interest rates?

The official cash rate isn’t the only factor that influences bank lending rates, but it’s one of the most important.

To make money, banks need to lend money out at a higher rate than they borrow – a home loan is riskier than a deposit account (a borrower can default on the mortgage or go bankrupt, whereas deposit accounts are guaranteed by the Australian government), which is why the interest rate you receive on your savings account tends to be lower than the interest rate you pay on your home loan. So an increase in the cost of borrowing money can affect you in different ways, depending on whether you’re a net saver or a borrower.

Why do interest rates matter?

Impact on loans and mortgages:

For Aussies looking to buy a home, interest rates are a key factor. A lower interest rate means lower and more affordable monthly repayments (everything else equal), On the flip side, higher rates can increase your costs, affecting your budget significantly. Learn more about how to make your home loan work harder here.

Savings growth:

Interest rates also matter for your savings. Higher interest rates mean more growth for your money over time. If you're saving for a holiday, a car or retirement, a good interest rate can help you reach your financial goals faster.

Economic influence:

Interest rates are a tool used by the RBA to control economic activity. By adjusting rates, the RBA influences inflation, employment and economic growth. Higher rates might slow down borrowing, investing and spending, while lower rates can encourage it.

Why should you care about interest rates?

Personal financial planning:

Understanding interest rates helps you make informed decisions about loans and savings. Whether you're looking to buy a house or save for the future, knowing how rates affect your finances can guide your choices.

Budgeting:

Interest rates can change over time, impacting your monthly expenses. Staying informed allows you to adjust your budget accordingly, ensuring you're prepared for any changes in your financial commitments.

Investment opportunities:

Interest rates also affect financial investments. They can influence stock market performance and property values. By keeping an eye on interest rate trends, you can make strategic investment decisions.

Economic awareness:

Interest rate movements are a reflection of the economy's trajectory. By understanding them, you gain insight into broader economic conditions, helping you navigate financial challenges and opportunities.