If you took out a home loan today, I’m sure you would know exactly how much interest you’d be paying.
Through a mortgage broker, you could choose from dozens of different lenders. Each one with dozens of products. The interest rates would be critical in helping you choose your loan.
If you instead go to a bank directly, the manager will likely offer you a special ‘introductory’ rate to get you across the line. A little enticement to take your business from your previous lender.
When it comes to bank accounts, however, I’d bet very few know the interest they earn. These are the transaction accounts we use every day — from depositing our salary through to paying our bills.
Perhaps there is a simple reason for this. We all know that even if these accounts pay interest, it is likely to be so small that it doesn’t even matter. No more than a few cents.
Take a closer look, though, and you’ll be surprised how many bank accounts just don’t earn any interest at all.
Plus, unless you keep a minimum balance — usually in the thousands — and put your salary into it, you’ll cop a monthly fee as well.
It’s only when you lock tens of thousands of dollars (or higher) into a term deposit for months at a time (or longer), that you will get something even close to 2%.
It is these accounts, which pay little or no interest, that form the basis of our banking system. Without this cheap and easy source of finance, banks would have to pay more to secure funding (from which it lends). And that means our mortgage rates would be higher.
How do banks rely on us?
Banks fund their loan books two ways. First, from all these millions of accounts that pay little or no interest. The second is by issuing ‘paper’ — meaning typically a bond.
Banks issue some of this paper in Australia. However, the banks also issue them offshore — mainly in the US.
Because of this, the banks have to deal with two major issues. One is managing foreign exchange risk — which they can, but it costs them a premium.
The second is all about interest. To attract investors, banks need to pay high enough interest.
When rates all over the world are, or were, negligible — sometimes negative — investors were only too happy to buy a bond that paid a (comparatively) handy return.
Though this dynamic has slowly started changing. What the banks are now facing is an increase in competition…and a re-pricing of risk.
As interest rates tick up in the US, institutional investors — that is, those that purchase bonds — will begin to have more choice. For a start, to fund its ever-ballooning deficit, the US Fed will need to offer higher rates to entice investors to buy their bonds.
That means our banks will also need to offer a higher interest rate to sell their bonds. Up until now, it has not really been a big increase — just one or two tenths of a percent. But it is something that could grow.
The other factor with any investment is risk. Interest rates have to reflect the underlying risk of these bonds.
In other words, for an American buyer of an Australian bank issued bond, they will assess the risk of the bank itself. However, it also has to reflect their view of the Australian property market.
Under the doomsday scenario — where proponents predict a property collapse — interest rates on these bonds could increase rapidly to account for this risk.
However, even with house prices going sideways, and drifting a little lower (as they are in some of the major cities and regions now), the overall cost of borrowing is beginning to rise. Not by massive amounts, as I say, but enough for the banks to want to pass on the costs.
That means those with a mortgage might soon see — if they haven’t already — the interest rate on their home loan ratchet up a fraction. It will remind mortgage holders that the banks can act on interest rates independently of the RBA.
A bank like the Commonwealth Bank Ltd. [ASX:CBA] enjoys a high level of customer funding. As of its most recent results, customer deposits represented around 68% of all funding.
However, it’s the other 32% — and higher for other banks — where the increase in funding cost will hit. That means that many of us could soon be paying more for our mortgage. That is irrespective of what the RBA does.
Depositors needn’t hold their breath for any thanks. Though banks will increasingly depend on them to help keep their funding costs in check.
All the best,
Editor, Total Income