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Why do interest rates change?

An interest rate essentially reflects the cost of borrowing. The lender charges interest as insurance against the possibility of a borrower not being able to repay the money, as compensation. It helps keep the economy moving by encouraging lending and spending money.

The reason they may rise or fall is a result of this supply and demand for credit. An increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will lower them. On the other hand, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.

Lenders adjust interest rates on loans based on a variety of factors, but much of it comes down to the lender’s costs of funding the loan.

There are broader markets from which lenders obtain the funds that allow them to make a loan, including bond markets and day-to-day lending between banks, which are influenced by various economic and market forces. When the costs of sourcing these funds rise (for example, bond rates rise), lenders often pass these costs on to customers by raising the interest rates on the loans they make.

Central banks – such as the Australian RBA – have a big influence on this cost of funding by setting a cash rate, which is essentially the overnight lending rate between banks. The RBA sets this cash rate based on whether it thinks the economy needs to be stimulated (for example, by cutting interest rates to encourage spending and stimulate economic growth and employment) or slow (for example, by raising interest rates to curb high inflation).

When you take out a variable rate loan, you take the risk of riding those highs and lows.