October 8, 2019 Bailey Underwood8 mins

Our funder, Bendigo and Adelaide Bank, has to consider many factors when they set our rates, which we’ll explain below. But because of the efficiency of our platform, we can offer much lower rates (to new and existing customers) because it’s cheaper for us to process our home loans. This means when you’re a Tic:Toc customer, you may not get the fresh new discount on offer, but you won’t get a rate hike just for the fun of it either. Because we don’t make our existing customers pay for the deals we can offer new customers. And we don’t believe in promotional or introductory rates.

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 three rate decreases: one in June, one in July, and one in October 2019 (due to drops in the Official Cash Rate). Our rate rise and three 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.

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…

…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:

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:

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.

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 pass on rate decreases?

Our funder, Bendigo and Adelaide Bank, has to consider all of these factors when they set our rates, which is why it’s just not possible for us to give the same variable rate to all our customers. But because of the efficiency of our platform, we can offer much lower rates (to new and existing customers) because it’s cheaper for us to process our home loans. This means when you’re a Tic:Toc customer, you may not get the fresh new discount on offer, but you won’t get a rate hike just for the fun of it either. Because we don’t make our existing customers pay for the deals we can offer new customers. And we don’t believe in promotional, or introductory, or 'honeymoon' rates.

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 three rate decreases: one in June, one in July, and one in October 2019 (due to drops in the Official Cash Rate). Our rate rise and three 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?