What Is The Deal With Interest Rates
Interest rates have been a hot topic on the news lately because they have been rising steadily from the lows of 2020 and 2021. But what do interest rates really represent and why do they move?
What are interest rates
Most of us have heard of interest rates, but how much do we really know about them?
Essentially interest rate is the cost of money. The flip side is that interest rate is the income that money earns.
Whether it is a cost or an income depends on which side you are looking at it from.
Confused? Maybe, maybe not.
For example, you take out a personal loan. You make weekly payments, some principal (= the actual amount of money you borrowed), some interest. Those interest payments that YOU make is a cost to you for borrowing the money in the first place.
At the same time those same interest payments are a form of income to the bank that lent you the money.
Have you by the way noticed how interest rates are always declared with a little “p.a.” behind them?
You might already know that this means “per annum” which means “per year”.
BUT the thing is, that the interest is most often calculated DAILY, and then added to your account weekly/bi-weekly/monthly.
This means that the true interest amount you end up paying is higher than the given annual interest rate (only a tad, but still).
What affects them
There are multiple things that affect interest rates. (And I’m mainly talking about the interest we pay on loans and such.)
The official cash rate (OCR), the lender, type of loan etc.
Official cash rate
Official cash rate, or OCR, is the interest rate that banks charge each other to borrow money shot-term.
It is set by the Reserve Bank Of New Zealand as a part of their monetary policy.
The OCR affects the rest of us because it is the base cost of money, which is transferred to consumers. The banks will then charge on top of this to make money.
This is why as the OCR has been rising, the interest rates charged to us have been rising as well.
The lender
Lenders are those who supply us with loans. They are banks and other financial institutions, and to a degree, they can decide their rates.
Bigger banks might charge you less because they have more customers than smaller financial institutions for example.
Type of loan
Out of these three the main difference in interest rates comes from what kind of loan is in question.
In general mortgages have lowest interest rates out of loan types, then personal and car loans and credit cards have the highest rates.
(I’m leaving out buy now, pay later schemes and pay day loans, will talk about them in another post!)
Some factors that play into this are whether the loans are secured or not.
In the case of mortgages, the mortgages are secured by the house that the loan is for. The reason why this is important is because if for any reason the person taking out the loan couldn’t pay the loan, the bank would take possession of the house and sell it, recovering the money they borrowed.
This makes mortgages less risky to lend out as there is a good chance for the lender to get their money back even if something goes wrong.
Lenders also do a very thorough due diligence before giving out mortgages, lowering the risk of giving loans to those who can’t pay them back.
And less risk to the lender, leads to lower interest rates.
Personal loans and car loans are similar to each other as they are often for a specific purpose. Car loans can also be secured by the vehicle, which can lower the interest rate.
Lenders also don’t do quite as thorough due diligence for these loans.
So in general these loans are riskier to give out, so they have higher interest rates.
Credit cards have notoriously high interest rates.
This is because the money borrowed using a credit card is not secured by anything, the due diligence isn’t as thorough and after the initial due diligence when credit card was taken out, you can keep going into debt within your limit even if your financial situation has changed.
These factors make credit cards riskier for lenders to give out, resulting in higher rates charged.
You can compare different interest rates offered by different lenders here.
What other words mean the same as interest rate
As always, the world of finance is full of jargon, and there are a few terms that pretty much mean the same thing. So, I thought I’d share them for reference!
As I mentioned, interest rate is the cost of money, but also the income it generates, depending on where you look at it from.
So another word for income from an investment (basically, money) is yield.
Yield is often used when spoken about the income that a property investment or bonds generate.
Another one would be return.
Return is often used when spoken about shares, but it can refer to any kind of investment.
The biggest difference between the two that often capital growth is not calculated when used yield but is usually included in calculations for return.
If you have any questions around this topic, please don’t hesitate to ask below! I’d love to answer them!
