Key Difference – Cash Rate vs Interest Rate
The key difference between cash rate and interest rate is that cash rate refers to the rate at which commercial banks borrow funds from the central bank whereas interest rate refers to the rate at which a financial charge is received\paid on saved or borrowed funds. In a broader sense, both these rates are a type of interest rates; however, there is a subtle difference between cash rate and interest rate.
CONTENTS
1. Overview and Key Difference
2. What is Cash Rate
3. What is Interest Rate
4. Side by Side Comparison – Cash Rate vs Interest Rate
5. Summary
What is Cash Rate?
Cash rate, also referred to as the ‘overnight money market interest rate’, is the rate of interest that commercial banks have to pay on borrowed funds from the central bank. The term ‘cash rate’ is primarily used in Australia and New Zealand, and has the same meaning as ‘bank rate’ used in other countries.
The central bank can increase or decrease the cash rate by a measure of ‘basis points’ in an effort to manage the economy. Cash rate indirectly affects the economy since respective funds are loaned to customers, having a strong relationship with interest rates. Whenever there’s cash rate rise or fall, the interest rates that banks charge on customer loans will broadly move in line with the change. Banks don’t actually have to follow the cash rate change when it comes to interest rates, but it’s usually in their best interests to do so. A bank that fails to pass on a cash rate reduces its variable mortgage holders; for example, risks losing customers and damaging its public image.
Figure 1: The relationship between cash rate and interest rate
What is Interest Rate?
Interest rate is the percentage charge on saved or borrowed funds. The interest rate may be calculated monthly, quarterly or annually while annual interests are the most widely used (Annual Percentage Rate). There are two principal ways in which interest is calculated.
Simple Interest
In simple interest, the funds lent or borrowed will grow depending on the rate of interest and the number of periods involved. Simple interest can be calculated as per below.
Interest = (Principal) (Rate) (Time)
E.g. an amount of $2,500 is borrowed at a rate of 5% for a period of 3 years. The interest payable at the end of 3 years will be,
Interest = $2500 *0.05 * 3 = $375
Total amount payable = $2,500+$375 = $2,875
Compound Interest
Compound interest is a method where interest received will continue to add up to the principal sum (original sum invested) and the following period’s interest is calculated not only based on the originally invested amount, but based on the addition of principal and the interest earned.
E.g. A sum of $2,000 is deposited for a period of 6 months at a rate of 10% per month. Future value at the end of six months can be calculated using the below formula.
FV= PV (1+r) n
Where,
FV= Future Value of the fund (at its maturity)
PV= Present Value (the amount that should be invested today)
r = Rate of return
n = Number of time periods
FV= $2,000 (1+0.1)6
= $3,543 (rounded to the nearest whole number)
Another common use of interest rate is related to the calculation of return from bonds, known as ‘coupon rate’. This refers to the annual rate of interest earned by an investor for a bond held.
E.g. If a bond has a nominal value of $2,000 that pays interest biannually at $30, the Coupon Rate will be 3% p.a. (60/2,000 *100)
Factors Affecting Interest Rates
Inflation
There is a positive relationship between inflation and interest rates, i.e., if inflation rates are high, interest rates are likely to rise as lenders will require higher rates as a compensation for the decrease in the lent funds.
Government Policy
Government affects interest rates directly through monetary policy (control of money supply in the economy). If the government wishes to reduce the money supply, they will increase the interest rates; this will encourage consumers to save more funds than spending and vice versa.
Figure 2: Fluctuations in interest rates may be caused by changes in Inflation and Government policy
What is the difference between Cash Rate and Interest Rate?
Cash Rate vs Interest Rate |
|
| Cash rate refers to the rate at which commercial banks borrow funds from the central bank. | Interest rate is the rate at which a financial charge received\paid on saved or borrowed funds. |
| Effect on the Economy | |
| Cash rate indirectly affects the economy. | Economy is directly affected by interest rates. |
| Parties Involved | |
| Cash rate is applicable to banks and other financial institutions. | Effects of interest rate is borne by consumers and corporates. |
Summary – Cash Rate vs Interest Rate
The difference between cash rate and interest rate principally depends on the parties to which they are applicable to. While cash rate is not affected by many external factors; interest rate is often a result of a combination of many other factors such as inflation and government policy. It should be noted that cash rate is similar to the bank rate with the exception of usage of the term in Australia and New Zealand.
Reference:
1. “Difference between interest rates and cash rates and effects on home loan planning.” Yellow Brick Road. N.p., n.d. Web. 17 Mar. 2017.
2. Heakal, Reem. “Forces Behind Interest Rates.” Investopedia. N.p., 19 Feb. 2017. Web. 17 Mar. 2017.
3. “Cash Rate.” Reserve Bank of Australia. n.d. Web. 17 Mar. 2017.
4. Amadeo, Kimberly. “What Are Interest Rates and How Do They Work?” The Balance. N.p., n.d. Web. 17 Mar. 2017.
Image Courtesy:
1. “Interest rate comparison – Savings accounts – Sweden” By Qenneth – Own work (CC0) via Commons Wikimedia