The ins and outs of interest
Posted on September 30th, 2016
Most of us will borrow money from a bank, credit union or other financial institution at least once in our lifetime. For some it will be a personal loan for an overseas adventure; upgrading to a new set of wheels or borrowing some cash to have that wedding you’ve been dreaming about since you were six. For others it will be something more long term, such as a mortgage to get out of the rental market and into your very first home or upgrading your current home as you move through life and do things like starting a family. No matter what stage of life you’re at you’ll need to know about interest.
What is it?
When you borrow money, the financial institution that lent you the money will charge you interest on top of the amount that you borrowed to be paid back. This is normally a small percentage of the total amount borrowed, or the interest rate. Your institution charges that interest to pay other interest on savings and term deposit accounts, plus they’ll be making a significant investment in you by lending you what can sometimes be huge amounts of money, so they need to mitigate their risk by regaining some cash through extra interest on top of your repayments.
But why are rates different from bank to bank?
In general the interest rates your financial institution can offer do go up and down with the economy and what the Reserve Bank of Australia (RBA) is doing, but why can one lender offer a different rate to another a block away? Most institutions use interest as a means to generate profit that keeps the bank running, and to reinvest into attractive products and services. But as well as that, they all hold varying amounts of money in services like term deposits and savings accounts that they’re paying interest on, so what they’re holding can influence what they can do in the lending department. Most of the time you’ll see these rates differing by only around 0.15%, or even less. It doesn’t seem like much but over the life of your loan that can really make a difference, so it pays to have a good look at what each lender is offering.
What rate of interest will I pay?
When you’re ready to apply for a loan there are a number of factors that decide how much interest you’ll actually pay. Most financial institutions will have different rates depending on how much you’re looking to borrow, your credit history and your ability to repay. With some loans, you may be able to get a better rate if you opt to protect your loan with additional insurance that will cover payments if you get sick or injured and are unable to earn income to cover your payments. This is something normally offered by your lender. Better still, you can secure your loan with an asset to get a better rate again. Basically you are offering up something of yours as collateral to the lender in case you can’t repay the amount and giving them the opportunity to sell the asset and cover the debt.
Another big factor is whether you opt for a fixed rate or a variable rate. A variable rate means the percentage of interest you pay can change. This means that if rates go up or down, your payments generally follow. For those of you who like a bit more stability, you can opt for a fixed rate, which means you pay the one rate regardless of changes elsewhere in the market. Most loans will only give you this rate for a few years, but it is a great way for first home buyers to get used to mortgage repayments or if you’re trying to stick to a budget. Sometimes you might not have the choice between the two, and it’s important to note that this depends on your particular financial situation.
This information is designed to broaden your financial knowledge but doesn’t replace the value of professional advice. We suggest you meet with your financial planner for advice that’s tailored to your individual circumstances.
The Capricornian Ltd, Australian Credit Licence No 246780.