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Home loan guide / Home loans explained

How banks and lenders set their interest rates

8 min read

Bailey Underwood

Ever wondered how banks and lenders decide what their interest rates are? We've put together a comprehensive guide to show you how interest rates are set and what it means when they move up or down.

Our funder, Bendigo and Adelaide Bank, has to consider many factors when they set our rates, which we’ll explain below. When you get a Tic:Toc loan, we’ve locked in a ‘price’ with our funder (Bendigo and Adelaide Bank) for that loan, which is reflected in your interest rate.

When we have a new variable rate for new customers, it means we’ve been able to lock in a lower price with our funder. It doesn’t change the price we secured for your loan. So, having a lower rate for new customers doesn’t mean we’re making more money off our loyal customers to pay for the discount – because we don’t believe in that. It means our funder has been able to give us a better price at that specific time. At some point, our funder may actually increase the price they’ve agreed with us, which means the rates for new customers will go up. And some existing customers will be better off.

The new rate offers work differently to cash rate changes. If there’s an RBA cash rate cut and our funder’s costs ease, they may be able to pass on the cut which means all our customers will receive the same discount off their rate – new and existing. The good news is, all of our rates are seriously good because of our tech-driven proposition. And even if your rates are a fraction higher than the new headline rate, you will still be saving thousands compared to the average loan.

Since launching in 2017, Tic:Toc has had one rate rise in August 2018 (set by our funder due to an increase in funding costs) and four rate decreases: one in June, one in July, and one in October 2019, with another in March 2020 (due to drops in the Official Cash Rate). Our rate rise and four rate drops were for both new and existing customers.

Let's break it down

Two numbers wield significant influence over how banks set their interest rates. The first: the Official Cash Rate, set by the Reserve Bank of Australia (RBA). The second: the Bank Bill Swap Rate (BBSW), set by market forces.

The Official Cash Rate (or interest rate) is a target set by the RBA and reflects the overnight money market interest rate. The overnight money market exists to fill gaps in liquidity between banks. This needs to be done as not everyone can have enough liquid cash at once, so those who need it more immediately will borrow it for a short period of time from those who have an excess. All this inter-bank borrowing is facilitated by the RBA.

This is essentially a core backbone of our banking system. The cash rate influences plenty of other things too, like the rate interest is accrued on savings, and the rate interest is accrued on debt.

The Bank Bill Swap Rate (BBSW) is a separate rate from the Official Cash Rate but the two are usually closely tied. It is a short-term swap rate, and the rate at which funds are exchanged between banks in the wholesale market. The BBSW is essentially the rate at which banks are willing to lend money to each other via bank bills. If this number is too high above the Official Interest Rate, it means banks are paying more to cover the cost of their funding (so, increased funding costs and potentially decreased profit!).

So, what does this mean?

This means different things can happen when the cash rate and BBSW fluctuate together or separately. If the cash rate remains stable but BBSW falls, wholesale market funding costs decrease, potentially assisting banks with making more profit.

Interest rate and Bank Bill Swap rate graph

This scenario played out not too long ago, when Tic:Toc lowered its variable rate from 3.57% to 3.47% despite the RBA not changing the Official Cash Rate. It became cheaper to fund loans, so we negotiated with our funder to offer you better rates! This is called an out-of-cycle rate decrease. Depending on their individual circumstances, some banks won’t pass on these savings in order to increase profitability.

But, when the cash rate is stable and the BBSW moves up…

Interest rate and Bank Bill Swap rate graph

…it becomes more expensive in the wholesale markets to fund loans, bank’s profit margins are squeezed, and to compensate? Your variable rate may be adjusted up to compensate your lender for the higher funding costs. This is called an out-of-cycle rate increase.

Very cool! Flip the table - what about that trusty interest rate?

Well, the cash rate hasn't moved up since November 2010. But here’s what usually happens when it rises:

Interest rate and Bank Bill Swap rate graph

When the Official Cash Rate moves up, it also becomes more expensive for a bank to operate. To maintain reasonable profitability, banks and lenders will usually pass this increase on in the form of a rate rise. If you’re on a fixed loan, you won’t be affected by a rate rise for the duration of your fixed period.

And finally: a decrease in the Official Cash Rate:

Interest rate and Bank Bill Swap rate graph

Less costs, more profit! This is great news for some, as your bank or lender may pass on these savings direct to you, the borrower, through a rate decrease.

But wait

It’s not all sunshine and rainbows. Remember before how I mentioned that interest rates affect how much interest is accrued on savings? Well, now that the interest rate has decreased, those with savings aren’t earning the interest they used to. So often, they may revisit their investment strategy and consider redirecting their cash to higher-yielding assets.

Oh no... so now there's less money in the bank?

Bingo. Less money, less liquidity. Since the banks use household savings as part of their funding mix when borrowing their own funds, they’ll need to replace those retail deposits with more expensive wholesale funding. And to borrow wholesale funds, you have to pay the BBSW. So, even though a decrease in the Official Cash Rate may reduce costs and increase profit immediately, it has the potential to increase costs and decrease profits in the short term.

Interest rate and Bank Bill Swap rate graph

This is where it gets interesting. Remember when we established how the Official Cash Rate and BBSW are usually closely tied? A drop in the Official Cash Rate will typically mean the market will react in kind, lowering the BBSW also. But if the difference or ‘spread’ between the two rates becomes too wide (market forces determine the width), it can potentially impact profitability for the banks.

And if profitability falls, they may find it more difficult to pass on a rate decrease to home loan customers. Or, they may only pass on the decrease to new customers.

Passing on rate decreases to new customers only

This is a very common move. Banks and lenders rely on the flexibility of their back book (read: their existing customers) to absorb the changes in the Official Cash Rate and BBSW. If existing customers never absorbed these costs (so if variable home loans didn’t exist), the bank would be far too susceptible to market forces. When banks are pushed around and swayed easily by these market forces, it decreases shareholder confidence in that bank, amongst many other things.

And why is this important? Well, when shareholder confidence is low, it has flow-on effects which can make the bank more vulnerable in the broader market. And a vulnerable bank is more at risk of becoming a takeover target, and of failing.

Banks have multiple stakeholders to care for; in some instances, shareholders take a backseat to customers. This can materialise as variable rates being held despite increased funding costs; banks will do this occasionally to look after their customers and gain a competitive advantage.

Will Tic:Toc always pass on rate decreases?

The short answer is no. But you'll always have a seriously competitive rate.

Think of it like this – when you get a Tic:Toc loan, we’ve locked in a ‘price’ with our funder (Bendigo and Adelaide Bank) for that loan, which is reflected in your interest rate.

When we have a new variable rate for new customers, it means we’ve been able to lock in a lower price with our funder. It doesn’t change the price we secured for your loan. So, having a lower rate for new customers doesn’t mean we’re making more money off our loyal customers to pay for the discount – because we don’t believe in that. It means our funder has been able to give us a better price at that specific time. At some point, our funder may actually increase the price they’ve agreed with us, which means the rates for new customers will go up. And some existing customers will be better off.

The new rate offers work differently to cash rate changes. If there’s an RBA cash rate cut and our funder’s costs ease, they may be able to pass on the cut which means all our customers will receive the same discount off their rate – new and existing. The good news is, all of our rates are seriously good because of our tech-driven proposition. And even if your rates are a fraction higher than the new headline rate, you will still be saving thousands compared to the average loan.

Since launching in 2017, Tic:Toc has had one rate rise in August 2018 (set by our funder due to an increase in funding costs) and four rate decreases: one in June, one in July, and one in October 2019, with another in March 2020 (due to drops in the Official Cash Rate). Our rate rise and four rate drops were for both new and existing customers.

In sum

When it’s expensive for banks and lenders to operate, it becomes more difficult to pass savings on to home loan customers. Banks want stability, as instability within a bank may cause it to sway (which is bad news for the broader economy). To protect themselves against shocks, they do what most investors do to reduce risk: they diversify. They spread the risk across all borrowers, so that anyone with a home loan can act as a shock absorber. Hundreds of thousands of shock absorbers. Anyone with a variable home loan absorbs these shocks through their variable rate varying.

After signing on for their home loan, customers are rolled onto the back book. This helps the banks to do three things:

  • be flexible when they need to be;
  • offer lower rates to new customers to grow market share; and
  • satisfy shareholders and maintain profitability.

It’s all interconnected; a delicate balancing act.


Learn more:

Why do variable rates change?

Borrowing power explained

What is LMI?

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