What are interest rates?
Good question. An interest rate is a fee you're charged for borrowing money, expressed as a percentage of the total amount of the loan.
So if you borrow money, either in a home, car or personal loan, you pay interest on it. If you’ve got your money put away in a bank, either in a savings account or term deposit, that more or less amounts to lending the bank your money, and so you will be paid interest as a lender.
The interest rate, set by your bank and based on the RBA’s official cash rate, determines how much interest you will earn or pay.
What does it all mean: the big picture
We all know the interest rate is important for borrowing or saving money. So what do changing interest rates mean in practical terms? Check out the table below for the effects of increasing or decreasing interest rates.
| High interest rates | Low interest rates |
|---|---|
| Aussie dollar gets stronger Lower returns for Aussie investors overseas Encourages saving Less disposable income Loan repayments increase Savings earn more interest |
Aussie dollar weakens Aussie exports are more affordable for overseas buyers Encourages spending More disposable income Loan repayments decrease Savings earn less interest |
Why do you pay interest?
Interest is basically the cost of money. You’re paying for the ability to use money you haven’t yet accumulated, so interest is an incentive for the bank to lend you money and a premium for the risk they take in lending to you. Charging interest is one of the ways lenders make their profit.
How is interest calculated?
Interest is usually calculated one of two ways, depending on whether it’s simple or compound interest. Simple interest is calculated as a percentage of your initial amount only, while compound interest is calculated (usually every month) on the entire balance of your savings or loan, including the previous interest payments.
The formula for simple interest is:
Simple Interest = principal x annual interest rate x years
Where will I earn simple interest? If you’ve stashed your savings in a term deposit, you’ll earn simple interest.
The formula for compound interest is:
Compound Interest = principal x (1 + interest rate) years
Where will I earn compound interest? Savings accounts and bank accounts both earn compound interest.
Where will I pay compound interest? Credit cards, home loans and car loans generally work on compound interest. While home and car loans are calculated to be paid off by the end of a pre-determined term, credit card interest can compound indefinitely. That’s why it’s a great idea to pay off your credit card balance as soon as you can.
Too much maths for your taste? Check out Mozo’s handy financial calculators to calculate your interest quickly and easily.
Types of interest rates
It’s not as simple as just searching for a high or low interest rate when comparing all the products out there on the market. There are also a couple of different types of interest rates and they each have their pros and cons. You’ll need to carefully consider which one is going to be best for your goals, lifestyle and budget. They include:
Fixed interest rates
This one is pretty self explanatory - a fixed interest rate is set at a certain percentage for the life of your loan or account. For something like a home loan, this might make budgeting a little easier, because you’ll pay the same amount of interest each month.
If you’re looking at a fixed interest rate, it’s important to shop around before you decide on one product - because once you’ve locked in an interest rate, you’re usually stuck with it.
Variable interest rates
A variable interest rate does just what the name suggests too - it varies. Depending on the market and the RBA’s official cash rate, your provider might raise or lower interest rates and those changes will affect the amount of interest you pay or receive.
When you opt for a variable rate, you do leave yourself vulnerable to unfavourable market changes, but at the same time, you have the chance to reap the benefits if the market shifts in your favour.
Comparison rate
The comparison rate is used to help buyers understand what a loan will really cost them. It’s given as a percentage value, and takes into account interest rates, fees and charges so that you can more easily compare what you’re getting when choosing a loan.
Comparing interest rates
Ready to find yourself a cracker deal? Head over to our interest rates comparison page to get started.
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