How interest rates work

Interest rates have a significant impact on our finances, so it is vital that we understand how to make them work for us.

What is an interest rate?

An interest rate is the cost you pay to a lender when borrowing money.

In our economy, the interest rates originate from the bank rate or repo rate, which is the interest rate at which the Reserve Bank lends to the commercial banks – currently at 6.75%. This is not the interest rate that consumers pay. The commercial banks add more percentage points to the repo rate to determine the prime rate – the rate at which a bank will lend money to its top (lowest risk) clients. Since November last year, the prime rate has been 10.25%.

Most consumers pay a rate even higher than prime. This is expressed in lending agreements as, for example, ‘prime + 1%’. This is called a variable, floating, linked or fluctuating rate because, as the repo rate increases or decreases, so will the interest you pay. For example, if you have a loan agreement with a variable rate of ‘prime + 1%’, you will now be paying 11.25% (10.25% + 1%) on that loan. However, if the Reserve Bank raises the repo rate, the prime lending rate will also rise and the interest you pay on your loan will also increase.

Some loan agreements, such as a home loan, allow you to negotiate a fixed rate that is not linked to the fluctuating prime rate. However, this comes at a cost.

How the interest rate affects you

When consumers pay less interest, they have more money to spend, which can create a ripple effect of increased spending throughout the economy.

The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars, which stimulates the economy. Conversely, the higher the rate, the more interest you earn on your savings. In addition, when it rises:

  • Home loan repayments increase
  • Your instalments for all other loans increase – vehicle finance, personal loans, overdrafts, credit cards, store accounts
  • The cumulative effect of an increase in bond repayments (often the biggest expense) as well as all other short-term loan accounts will impact significantly on monthly cash flow

How to make the interest rate work for you

  1. When you take out any kind of loan, be aware that the interest amount on the loan will need to be repaid over and above the original sum of money you borrowed. Consider if it is a good investment: in some cases, the interest payable is acceptable – for example, on a home loan, which will ensure that you have a property asset and a place to live. However, it makes far less sense to pay a fortune in interest when borrowing money for – as just one example – a holiday or a fancy car.
  2. Know what interest rate you are paying on each of your loans, so you can focus on paying off your highest-interest loans first.
  3. Before you sign any loan agreement, shop around and negotiate the best possible rate, and make sure you can meet the repayments at the current interest rate, as well as after a rate increase.
  4. Contact your credit providers on a regular basis to request a rate reduction.
  5. When choosing a savings vehicle, make sure you are getting the highest interest possible. Even half a percentage point makes a big difference over the long term.

The information is shared on condition that readers will make their own determination, including seeking advice from a financial professional. E&OE.

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