Interest Rate Definition

What is an Interest Rate?

Interest rate is the amount of interest that a lender charges to a borrower for the use of assets (cash, consumer goods, property, vehicles), it is expressed as a percentage of the amount borrowed or gained as profit.

In simple terms, the interest rate is the cost of borrowing that the country has, this is what commercial banks will charge you when you are borrowing money.

The South African Reserve Bank regulates the repo rate – repurchase rate (currently at 3.75%), which is the cost that they impose on commercial banks. This helps the reserve bank to manage and regulate the flow of money in the country, know how much money is currently in our economy, and how strong our currency is.

Types of Interest Rates:

1. Prime Interest Rate

The prime interest rate which is also known as the prime lending rate is linked to the repo rate. It is defined as the basic rate that commercial banks (Nedbank, FNB, Standard Bank, Capitec, ABSA, Investec, African Bank, etc.) charge clients when borrowing them money for big purchases such as a car or a house. When the repo rate fluctuates, the prime interest rate changes by the same margins.

When you apply for car finance or a home loan, the bank weighs the different risk factors of loaning you the money, this determines if you will be charged an interest rate that is above, below, or equal to the current prime interest rate.

The prime lending rate is higher than the repo rate as it currently sits at 7.25%. However, it is good to know that the prime rate is at its lowest level since the year 1973, making it the best time now to opt for a variable interest rate as the prime rate is low, and so will the repayment be.

2. Fixed Interest Rate

Fixed interest rate literally explains itself; it is fixed interest throughout the repayment period. This means that on that day that you fixed that interest rate for that period that you have been given as a fixed interest rate term, it will stay the same.  This is the most common interest type for consumers as it is easy to calculate, understand, and that it is stable.

The fixed interest rate is generally higher than the variable interest rate because they think they are giving you a better proposition by fixing your rate for the next five years.

3. Variable Interest Rate

A variable interest rate is a total opposite of fixed as it is linked to the movement of the interest rate, meaning it can change when the reserve bank changes the interest rates in the country. So, if the reserve bank decides to hike the interest rate in the country, then it means that your interest will be hiked accordingly by your commercial bank, and you will pay a little bit more in terms of your instalment.

Conversely, if the prime rate goes down, you will then pay less as per the new rate.

4. Compound Interest Rate

Compound interest rate is the interest of interest. It is made up of two elements which are the interest of the loan and the principal amount. With this method, the borrower pays more in interest. In essence, banks apply the interest amount on the loan balance, and whatever balance is pending will use the same amount to calculate the subsequent year’s interest payment.

5. Simple Interest

This is the rate that banks charge their clients, and it is calculated through the multiplication of principal interest, interest rate, and the number of periods (principal X interest rate X time).

Ways to Reduce Your Interest Rate

You have the power to reduce your interest rate charges before applying for any loan by:

Saving up

You can beat the interest rate and get charged less if you have a large deposit for your purchase. The higher you deposit, the lower your interest rate.

Shopping around

Don’t settle, shop around and compare before you commit. The lending policy varies from one bank to another, you may find a bank that has the most suitable package for you.

Working on your credit score

This is very important, your credit score says a lot about your financial situation so, you better get your financial status in order. This will be used to determine how much of a risk you are. Any Improvement to your credit score can work in your favour and help you qualify for a lower interest rate. You can improve and maintain it by paying off your existing debts and making sure you pay them timeously.

Not sure which interest rate type to go for?

As a consumer, it is important to understand the different loan interest rate structures.

You have a right as a consumer to choose the type of interest rate you want; you can ask your consultant about your options. And before you decide and commit to any interest rate, do your own maths and compare.

The best choice of interest rate lies in your financial situation. You may go for a fixed interest rate if your budget is too tight and you cannot afford any effects from fluctuations, and if the market conditions show that the interest rate will rise in the coming years.

You may get an overview of the interest rate market in South Africa from the South African Reserve Bank (SARB) current market rates page and the Rand Merchant Bank (RMB) fixed income rates page.