Interest rates play a considerable role in the cost of debt. Yet, many consumers are still unsure how to navigate, negotiate, and plan for it. This is because credit doesn’t come as a one-size-fits-all package.
In the second part of our Debt-ucate series we explore interest rates – from how to get a better rate to what influences it, and how this affects the cost of your debt.
Tip: To find out more about how you can better manage your debt, click here.
Often your financial situation dictates your debt burden. If you’re in a fix and not sure how you’ll make it to month end, you’re probably looking into a payday loan. If you want to extend your home you may be after a larger-sized personal loan.
The amounts borrowed and repayment periods may differ, but there’s one variable that remains desirable – an affordable interest rate.
What affects your interest rate?
There are a few external economic factors that affect your interest rate, according to Old Mutual. These include inflation, the repo rate, and supply and demand at a certain provider.
“Interest rates are partly based on economic factors that are subject to change over time,” Old Mutual notes. “While you may have no control or influence over it, you can learn what to look for, monitor the changes and know when the best time is to apply.”.
But there are factors that are well within your control that you should be aware of, whether you’re applying for debt or paying it off.
Lender’s risk and credit type
Interest rates are often dictated by the risk that a loan poses to the lender. What this means is that you essentially pay a premium for using the provider’s money. This is how lenders make a profit.
Usually, the repayments you make on a loan will be made up of two parts - the capital, or part that reduces your loan balance, and the part that covers the interest on the loan.
“Where many consumers go wrong is that they simply factor in the capital amount of the loan, and forget to consider the interest. This means that they simply budget for the balance of the money borrowed, and not the cost of using the provider’s money,” says an Absa consultant.
“Consumers are often then trapped into paying towards a debt that they can’t afford. Otherwise, they’re stuck in credit agreements where the interest over the lifespan of the repayment period exceeds the capital borrowed.”
This means shorter loan terms will generally mean higher repayments, but less interest in the long run, while longer-term loans mean lower monthly repayments, but cost more in interest over the entire lifespan of the loan.
“It’s often tricky for consumers to grasp expensive short-term loans with lower interest rates, and home loans with cheaper repayments but higher interest rates,” says the Absa consultant.
“I always advise that they regard the debt in its entirety. Instead of simply considering the capital amount borrowed, they must consider the entire cost of the debt, and the interest owed over the lifespan of the repayment schedule.
“This will allow them to put into perspective what they’ll be paying towards the cost of borrowing the money. This way they can make a realistic comparison between providers and make the best decision for themselves.”
Credit score
This plays a big role in determining your interest rate because it tells lenders what kind of payer you are. Your credit record reflects your debt responsibilities, your payment track record, and debt affordability.
Upon applying for credit, providers consider your credit record and score to discern whether you can afford the credit, whether it’s a good idea to lend the money to you, and whether you’re likely to pay the money back as agreed.
“Maintaining a healthy credit score means providers consider you a lower risk and so you’re granted a cheaper interest rate, and vice versa,” says an in-branch Absa consultant.
The interest has the ability to make the cost of your debt far more expensive than it need be, so it’s wise to manage your credit score carefully by meeting all of your debt agreements on time, and budgeting correctly instead of using further credit to service current debt.
Fixed or variable interest
Then comes the decision of whether to opt for a fixed- or variable interest rate. There’s no right or wrong answer here, as this decision depends heavily on your pocket and personal circumstance.
Fixed interest
A fixed interest rate is exactly as its name suggests. The interest is set and it doesn’t change over the duration of the loan. This means that it’s not influenced by any external economic factors, such as the repo rate.
The advantage here is that, should the repo rate and inflation increase, you’re safe in knowing that the cost of your debt and repayments will not be affected. Therefore, there’s less risk in using this option.
But on the flip side, should the repo rate drop, you won’t benefit from the resulting lower rates which would cause your debt to be less.
Variable interest
A variable- or adjustable interest rate is the opposite of the fixed-term option. Here the interest is completely vulnerable to economic factors, such as inflation and the repo rate.
Simply put, if the repo rate goes up, the cost of your debt will too. But should it drop, you’ll save money. This means that you can start out paying a certain percentage in interest, and a year later you’ll be paying significantly more, or possibly less.
Which do you choose?
It’s important to consider your personal financial situation when deciding whether to opt for a fixed- or variable interest rate. Which one offers you the better deal? If the interest rate increases, can you afford it? If you’re unsure, speak to a financial advisor.
Understanding your credit agreement and the costs associated with it, such as your interest rate, goes a long way in determining whether you can in fact afford it.
The majority of South Africans find themselves in a position where they’re unable to meet their debt obligations. While this is due to an array of factors sometimes outside of their control, the one thing you can do is educate yourself so that you’re able to make better financial decisions.
If you can’t afford your debt and need help paying it off, click here.