How to Select a Lender Part 3: Interest Rates
In Part 2, we outlined the different products and services that lenders can offer, and why sometimes just going for the lowest interest rate may not actually be the best financial option for the consumer. It’s possible for less to be more, but in order to best take advantage of this, it’s important to get a good grasp of what an interest rate actually means.
What is an interest rate?
In its simplest terms, an interest rate is the money a lender makes for loaning out money. It’s what makes the financial system go round, and allows consumers to borrow money in a way that makes good financial sense for both parties.
From the bank’s point of view, the most important factor in determining an interest rate is risk. If a loan is risky, the bank is more likely to lose their money, as the customer is less likely to be able to pay it back. Therefore, they have to charge a higher interest rate to compensate for this additional risk.
There’s also interest to add in order for them to make a profit, and it's often this part of the rate that a lender will cut into, so they can compete for more business.
What are the components of an interest rate?
Base rate: what the bank charges by default for a product. At the time of writing, the current rate for garden-variety variable loans sits around 5%.
Discount rate: this is where lenders can use their discretion, to try and get a larger discount for the customer. As an example, a banker might be able to get a discount rate of 1%, but a broker arguing between two lenders can advocate on behalf of the client to increase the discount rate to 2%
Customer rate: It is the base rate minus the discount rate. For example, if the base rate is 5%, and the bank is offering a 3% discount rate, the customer rate will be 2%.
How are interest rates calculated?
Every day, the bank checks the loan balance and adds a small amount to a hidden total that builds up over the month. Usually once a month, the bank then takes that total and adds it to the total debt in the account as interest. The total is returned to zero. Another way to phrase this is that lenders calculate interest daily, and (most commonly) charge interest monthly.
For example - Bobby owes the bank $100. He is paying 365% per annum, which equates to $1 per day. From 1st Jan to 31st of Jan, the bank adds $1 every day to a hidden total, and on the 31st of Jan, adds the final $1 and charges the full $31 dollars of interest to the debt. At the end of the 31st of Jan, Bobby now owes the bank $131 dollars.
What happens if I put some extra money in my offset the day before I have to make a repayment? Will I be charged the same amount of interest for the month? Will my repayments get smaller?
It’s important to know that since interest is calculated daily and charged monthly, putting extra money in your offset will only reduce the interest added on that day. You’ll still pay the full amount of interest calculated for every day that month. However, for the next month, that offset money will continue to reduce the interest calculated every day, so it will make a difference to the following month’s interest.
Another key factor in calculating repayments is that they will stay the same throughout your loan term. From the bank’s point of view, offset would reduce the total interest accrued, so would either reduce repayments per month or how long it takes to pay the loan back. If the bank is getting less money coming back to them, it’s more time that they can’t lend money to other people, so instead of reducing repayments, they prefer to reduce the loan term.
In conclusion, we’ve established that interest rates are important, but there’s still more that goes into determining how interest rates are changed between customers and scenarios, along with the difference between fixed and variable interest rates and which ones better suit which customers. For any further assistance in determining how to achieve not just an amazing rate, but an even better outcome to a financial situation, contact us at Lite Financial for a free discussion.
Information Disclaimer:
Any advice provided is general and does not take into account individual objectives, financial situation and needs. All individuals should consider whether the advice is suitable for them and their personal circumstances.
