What influences interest rates?

While the announcement of a rise in interest rates usually sends the media into a feeding frenzy, and home owners desperately clutching onto their wallets in fear of higher monthly payments, this decision by the Reserve Bank actually indicates a healthy, confident economy.

This is how it works. Basically, if economic indicators such as employment and growth patterns are favourable, this means that people are likely to start spending more. Out of control spending influences all types of things, such as the foreign exchange rate for our Aussie dollar and inflation (rising costs of goods and services.) Therefore, to encourage people to rather save their money, interest rates increase - so people are rewarded to save, and have less pocket money to spend (due to higher loan repayments). This is how higher interest rates help control inflation. If people have less money to spend due to higher interest rates, there is more competition among sellers of goods and services so they need to be competitive with pricing.

The opposite is also true. In a struggling economy, spending helps businesses survive, so the Reserve Bank lowers interest rates to encourage retail and business activity by freeing up more of our money.

It is worthwhile to remember that as rates rise, the amount you can borrow from the banks or lenders decreases (your serviceability drops) simply because your repayments will be higher.