Unpacking interest rates

Unpacking interest ratesLast month, the South African Reserve Bank cut rates by 100 basis points and this led to many questions about the mechanism of interest rates. We unpack how interest rates work both for borrowers and savers.

What is the difference between the repo rate and the prime rate?

The repo rate is the rate at which the South African Reserve Bank lends money to the banks as what is called “a lender of last resort”. The repo rate has been reduced from 6.5% to 4.25% this year so far. The repo rate underpins all lending and deposit rates in South Africa and is therefore a way for the Reserve Bank to influence the extension of credit in the country.

Listen to Maya and Mapalo Makhu discussing this topic in the My Money, My Lifestyle podcast.

It is important to note that banks do not necessarily borrow from the Reserve Bank and usually borrow in the interbank market (they borrow from each other depending on their liquidity needs). The interest rate in this interbank market is known as the Johannesburg Interbank Average Rate (JIBAR) which is usually higher than the repo rate.

The prime interest rate is the benchmark that banks use to price the risk of lending. “Prime” is the benchmark rate for a customer with a good credit record. A bank will price above or below that, depending on the underlying risk posed by the specific customer, the type of loan, as well as the current risk appetite of the bank.

So, although the prime rate is the same across all banks, banks still compete on the interest rates they charge a specific customer. The prime interest rate is linked to the repo rate and is currently 3.5 percentage points above the repo rate, at 7.75%.

Does a bank have to cut interest rates on loans when the repo rate is cut?

The maximum interest rates a credit provider can charge are determined by the National Credit Act which stipulates a percentage above the repo rate. For example, a personal loan cannot have an interest rate higher than 21 percentage points above the repo rate (ie, 25.25%), a credit card maximum is 14 percentage points above the repo rate (ie, 18.25%) and the maximum for a mortgage is 12 percentage points above the repo rate (ie, 16.25%). Loans of up to six months have a set maximum rate of 5% a month.

In most loan agreements, credit providers use the prime interest rate as their basis, rather than the repo rate, although the prime rate is linked to the repo rate and the NCA maximums still apply. Your loan agreement will stipulate that the rate you pay is linked to prime and will move in line with changes to the prime interest rate.

This means the interest rate charged on your debt will be impacted by a rise or fall in the repo rate, since this impacts the prime interest rate ‒ unless you opted for a fixed interest rate for the period of your loan. Some people want certainty that their debt installments will not increase, so they choose to fix their rate. While this protects them when rates go up, they will not benefit from a rate cut.

Will I get less interest on my savings account?

A cut in the repo rate also impacts the amount of interest you receive from your deposits at the bank. Deposits are affected by the prime interest rate, as banks use deposits to provide loans. If they are receiving less interest from loans, they will pay the depositor less interest.

However, there is more discretion when it comes to deposit rates. If banks are looking for more deposits, they may compete for deposits by offering attractive deposit rates.

In the last rate cut, we saw many banks only dropping their deposit rate by half a percentage point. Some banks, such as African Bank and Tyme Bank, even maintained their higher deposit rates.

The good news is that if you already have a fixed deposit, the bank cannot reduce the interest rate that it gave you at the time you took out the fixed deposit.

How soon after a rate cut is my mortgage or car finance rate adjusted?

According to Nedbank, when the Reserve Bank announces changes to the interest rate, the interest rate linked to the home loan account is adjusted immediately.  As the interest accrues daily, this means that in the case of this rate cut, from April 1 to April 14, the daily interest would have been calculated at 8.5% and from April 15 to April 30, the daily interest would have been calculated at 7.5%.

The instalment on the home loan account is recalculated as at April 15, with the newly updated instalment due on the 1st of the following month, providing an immediate benefit to customers.

Should I fix my interest rate?

With interest rates currently so low, is now the time is to fix your home loan rate? The problem is that fixed rates are always higher than the current rate, in the same way that a bank offers a higher interest on longer-term fixed deposits.

Steven Barker, head of lending products at Standard Bank says rates are more likely to be reduced further, so it may not make sense to fix your interest rate. Standard Bank currently offers fixed-rate contracts on home loan agreements over 12 months at 7.75% and fixed-rate contracts over 36 months at 9%.

“The fixed rate being offered will depend on the interest rate outlook at the time the contract is entered into. We typically find that fixed-rate agreements cost less when interest rates are expected to reduce, and conversely cost more when interest rates are expected to increase.”

FNB says that if a customer wants to fix their rate for 36 months, they will be charged an additional premium of 1.1 percentage points. In other words, if your current rate is at prime (7.75%,) your new fixed rate would be 8.85%. For a five-year fixed rate, you would pay 9.85%.

Rather than fixing at a higher rate, increase your repayments. For example, on a R500 000 mortgage, rather than fixing for 36 months at 8.85% just increase your current installment by R350. You know you will be able to absorb any future rate hikes and that extra payment goes straight to paying off your capital rather than servicing a higher interest rate.

Can I use this rate cut to reduce the term of my loan?

If you can continue to meet your usual bond repayments prior to the rate cut, these rate cuts offer an excellent opportunity to reduce the term of your loan. For example, on a R500 000 mortgage, this rate cut will reduce your repayment by R350. If you continue to pay this into your mortgage you could pay your home loan off nearly two years earlier – assuming rates do not increase again.

The same applies to car finance, however you do need to contact your car financing house to ask them to maintain the original repayment amount.

Faisal Mkhize, managing executive: Absa Vehicle & Asset Finance Trade Centre, Absa retail and business banking division, says customers can provide the bank with an instruction to increase their instalment amount or set it at a fixed monthly payment (equal to their instalment prior to the interest rate cuts). The bank will then restructure the loan agreement, which will result in a reduction of the finance term (and interest paid). Another option is to set up a stop order to increase those payments.

This article first appeared in City Press.

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