Even if you haven’t applied for a home loan, you will have undoubtedly heard the term “interest rate.” Interest affects loan repayments, but it can also help us make more money. So, what is interest? How is it calculated, and how does it change from product to product? Read on, dear friend as we dive into the wild world of interest.
What is interest?
Interest is the cost of borrowing someone else’s money. When you borrow money for a home loan, the interest you pay is the cost of borrowing the lender’s money and covering the risks that are incurred by borrowing such sums of money. Conversely, if you were to lend money, say by depositing funds in a term deposit account, you will gain interest on your money lent.
I call the shots.
Interest rates are primarily calculated off the cash rate set by the Reserve Bank of Australia (let us call them the RBA from now on). The RBA sets an official cash rate based on market activity and the supply and demand of exchange settlements. A deep understanding of this system requires a university degree, but for all intents and purposes, if the cash rate is low, so are interest rates.
Interest rates are calculated daily, but the rise and fall usually follows a slow pattern and aren’t usually much different from day to day.
What does all this mean for me?
When you apply for a home loan, much attention is focussed on the interest rates and with good reason. The lower the interest rates, the lower your mortgage repayments will be. When taking out any sort of loan, the money you borrow is subject to interest. Several factors determine the exact rate of interest that you pay.
As we have already discussed, the RBA sets a cash rate, which sets interest rates. Your exact rate of repayment is based on this cash rate, as well as the amount borrowed and for how long. Usually, a home loan attracts a relatively low-interest rate as you are paying back the amount borrowed over a long period.
Every time you borrow money, whether it’s a small Afterpay loan or a hefty personal loan for a shiny new car, your lender can choose to report your interaction with them to a credit agency who will give you a “credit score.” If you successfully pay off the loan without any problems, your credit score goes up, inversely, if you fail to make payment or default on a loan, your credit history goes down.
When applying for a loan, your credit score and history are evaluated by the lender to determine how risky you are to lend money too. This risk or lack of has a big input in your repayment interest rates.
Some ways to reduce interest.
A high-interest rate is good if you are investing money but not so much when it’s applied to your mortgage repayments. Being debt-free with a good credit history is the best way to lower interest rates, followed closely by a solid history of savings and long term employment. The more reliable your personal situation, the less risky you are as a borrower, and the less interest you will attract.
Interest is all around us, from Afterpay to home loans. Having a surface knowledge of what interest is and how it affects you can save you a small fortune in repayment fees. Being consistent, responsible, and diligent will reduce your interest rates and make everything easier in the long run. Saving money, getting better value products and services all because of interest rates? Sounds pretty interesting to me.