This transcript was generated automatically and may contain small errors.
What actually is the cash rate? And how does it affect the interest rates you and I get charged? How does the choices of a small group of people end up saving or costing us thousands of dollars in our mortgage repayment? In the next few minutes, you're going to understand who the RBA actually are, what they do, and how the cash rate affects the financial life of you and me. I'm Joma, Senior Research Analyst at InvestorKit.
Let's get into it. First off, who is the RBA? The RBA is the Central Bank of Australia. They issue banknotes. They oversee the resilience of Australia's banking and finance systems.
And they use monetary policy to make sure Australia's inflation stays low and stable so that we have healthy employment and healthy economic growth. And the most important monetary policy tool they use is the cash rate. So what actually is the cash rate? Technically, cash rate is the overnight rate on unsecured loans between banks. We can simply understand it as the wholesale price of money when banks borrow from each other.
On the screen, I'm showing you the cash rate trend line from 1976 to 2025. You may be wondering why it seems so fluctuating before 1990 and becomes smoother after 1990. That is because in 1990, cash rate target was introduced. Before 1990, there's no cash rate target. And cash rates were just recorded as they were by the RBA.
And in January 1990, the RBA introduced cash rate target and they started using market operations to make the real cash rate stay as close as the cash rate target. And since then, the cash rate we see on RBA's website has become the cash rate target, not the actual cash rate. Now, what's the difference between cash rate and interest rate? Simply put, cash rate is set by the RBA and interest rate is set by the banks when they lend money to us. How do they decide what interest rate they're going to use?
So basically, interest rate has two parts. One is the base, the cash rate, and the second part is a margin that banks add on top of that cash rate. That margin would cover several things, including their operation costs, their risk of borrowing default, and their profit for shareholders. So by adding all these extra costs to the cash rate, we get the interest rate we are facing when we borrow from the banks. In recent years, the interest rates always follow the moves of the cash rates.
When the RBA increases or decreases the cash rate by 25 basis points, what we usually see banks do is to also increase or decrease their interest rate on variable rate loans by the same amount. But actually, sometimes banks don't do the same as RBA does to the cash rate. I'll give you two examples. One was in 2008. From 2008 to 2009, the RBA dropped the cash rate from 7.
25% to 3% in around a year. That is 4. 25% drop in total. But when it comes to the banks, the total drop in mortgage rate was just around 3% because banks were considering risks from the global financial crisis. A second example is around 2019 when the cash rate dropped from 1.
5% to 0. 75%. But when it came to the banks, they didn't actually drop their interest rates by the same amount. For each 25 basis points drop, banks normally just did 15 to 20 basis points drop in their mortgage rates. So as you can see, interest rates do not always follow cash rates changes in full.
And now, how does cash rate impact our financial life? We can feel it directly and indirectly. Directly impact would be our repayment size and our borrowing capacity. Each 1% rate cut would translate into $416 less repayments per month for a $500,000 loan. And because of the improvement in serviceability, we can, as a result, borrow more.
A rough estimate now is that 1% rate cut would increase our borrowing capacity by approximately 10%. But that's a very rough estimate. If you would like to understand how much the rate cuts now is affecting your borrowing capacity, it's a good idea to talk to your broker or your banker. And now, indirect impact. Cash rate impacts our life by influencing consumer sentiment.
And consumer sentiment can affect property market demand in certain markets. High-priced markets with a large amount of speculative buyers, such as Sydney, Melbourne, and now Brisbane, Gold Coast as well, they are the most sensitive markets to cash rate changes. On the other hand, affordable markets, they are not as sensitive to interest rates as the more expensive markets. So to summarize, the RBA is Australia's central bank, and the cash rate is their major tool to stabilize Australia's economy. Overly simplified, cash rate is the cost of money when banks borrow from each other.
And interest rate is the cost of money when we borrow money from the banks. For investors, we don't want to just track the RBA cash rate changes. More importantly, we want to watch how different markets are responding to cash rate changes and make our decisions based on our own financial situation as well as the market conditions. If you want to have a deeper understanding on how cash rates impact property markets, like high-level investors do, check out our comprehensive white paper that is packed with detailed analysis put together by me and the rest of the InvestorKit research team. Some of the data inside is key for us to make decisions on where markets are and when potentially they're going to move.
Check that out in the link below. I'm Joma, Senior Research Analyst at InvestorKit. I'll see you next time.
