All About Interest Rates
When it comes to interest rates, there’s no silly questions.
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The media always goes on about fantastic interest rates.
If you’ve ever thought about buying something, heard about loans on the nightly news, or seen a credit card ad, then you’ve probably heard about interest rates.
All this information can be bamboozling: what is an interest rate? How is it calculated? What’s good, what’s bad?
Let’s start at the beginning.
How do banks or lenders come up with an interest rate?
There are two factors that lenders consider: the risk-free rate and the risky rate. Lenders add these two rates together to come to the total interest rate that they will offer.
So, risk-free interest rate + risk interest rate = total interest rate.
But you see only the total interest rate, not the rates the bank has used to create it.
Let’s break that down a little bit further.
The risk-free rate is the cost of the bank borrowing the money.
Lenders use a risk-free rate to show how much it costs them to borrow the money from the government; this rate is often called the base rate.
The risky rate is different. It can be rather large and often the major component of interest on a loan.
The risky rate is interest charged by the bank for the risk or fear that you might not pay back the money or the bank might not get their money back (also called a default rate).
This means that the interest rates for credit cards, for example, are higher than for a mortgage. Why?
It’s because the bank can always take the house, so the interest for a mortgage is usually closer to a risk-free rate than a risky rate.
But for a credit card, the bank can’t exactly take back the coffee that you just bought on your credit card.
The risky rate changes depending on the risk the bank perceives.
The fact is that many people default on loans. It happens; it’s life. People’s credit cards go into default, they can’t pay back their debt, and the bank doesn’t get their money back from those individuals.
To compensate for this statistical expectation, the bank will charge higher interest rates for loans with higher default rates and lower recovery.
A credit card will have a much lower recovery and a much higher default, therefore a higher interest rate for every credit cardholder. So, people who pay back their credit cards pay back higher interest to cover all the people who cannot pay off their cards.
The converse could be true. A mortgage would have a low default rate and a very high recovery rate. Therefore the interest rate is much lower because the bank is not at risk of losing the loaned money.
If you have a high interest rate, should you be worried?
Understanding your interest rates is vital for your financial freedom and security. I can never emphasise this enough.
If you can learn one thing about finance, it should be interest rates and what interest rates you are paying.
Lending institutions charge interest rates, and they can be extraordinarily high. Which, over time, will cost you an extraordinary amount of money.
I encourage clients to consolidate loans and debts into the lowest possible interest rate.
If you feel you can’t afford to live without borrowing money, ensure that your interest is at the lowest possible rate. Spend some time shopping around. You will find most institutions are eager to take your business, particularly if you have a good credit history.
What to remember about interest rates?
- Interest rates are calculated by a risk-free rate and a risky rate.
- The risky rate is dependent on the probability of default (and quality of the collateral, i.e. ability to recover some money) — risky rates are higher for loans that people are more likely to default on and more difficult to recover money from, like credit cards.
- You need to get your interest rates as low as possible — you can do this by shopping around and consolidating your loans.
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This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.
