So you’ve finally bought that property using a home loan. A month later, the reserve bank governor releases a statement that the interest rates are going up. This is followed by an SMS from your bank, notifying you that you will pay much more monthly.
Many of our loans are variable interest rates and are often quoted as prime plus or prime minus. But what is the difference between the repo and prime lending rate?
What is the difference between the repo and prime rate?
In the current financial system, the South African Reserve Bank lends money to banks and financial institutions – at a cost. This is the repurchase rate. To make money, the banks need to pimp out this money, but they need to make a profit. They generally quote their profit baseline as prime, which is repo + profit.
The prime rate is the lowest rate of interest at which money may be borrowed commercially for someone with a good credit score. In some cases, you might have an amazing credit score and the bank will offer you an interest rate lower than prime.
Why do interest rates increase?
Reserve and central banks use interest rates to control the supply and demand of credit. If they want people to spend less money and tighten their belts, they increase interest rates. Each country has a monetary policy that dictates when an interest rate change is allowed or implemented. In South Africa, the monetary policy dictates that we need to keep inflation below the 6% mark. If inflation goes above this mark, then the reserve bank increases the repo rate.
Some countries increase rates for other reasons such as making sure their currency is stable and maintaining trust in the economy. An example of this is during the COVID-19 hard lockdowns, many governments dropped the repo rates substantially to save the economy from collapsing.
How interest rates affect the economy
As interest rates have to do with the supply and demand of money, it’s bound to affect loans, property, spending and investing. When you’re working, the one we’re all most worried about is loans. When retired, we focus on the effect that this has on our investments.
How interest rates affect me
Interest rate changes affect everything from savings, investments, loans – and even exchange rates! This in turn affects your money directly. Let’s unpack a few of these.
How interest rates affect my loans
In short, the higher the interest rate, the more you’re going to spend on your loan. The lower the interest rate, the less you’re going to pay on your loans. As the repo rate cannot be negotiated, it’s worth negotiating the prime rate that your bank offers you.
The best example to illustrate this is the property industry.
As a property investor, I can clearly see how interest rates affect my pocket. For example, on a R 1 000 000 property with an interest rate of 10%, we’re looking at a rate of R 9 650.00 per month repayment. If interest rates go up by 0.25%, that would be R 9 816.00 – a difference of R 166 per month or R 39 840 over the 20-year loan term. Due to the long-term impact that this has on my property investments, I try and negotiate my interest rates down as much as I can – and encourage you to do the same!
How interest rates affect my savings and investments
As you get older, you want to keep your investments safe. Sadly, if interest rates are low, the interest the banks pay is also affected. If you’re living off the interest, you might need to start digging into your capital to survive.
But this we know.
Interest rates and bonds
What is not so apparent is the impact interest rates have on your investments such as bonds. The example below will illustrate the effect of interest rates on bonds:
Let’s say you have a bond that pays 7% interest per year. If the SARB hikes interest rates to 10% in one year, the bond will still pay 7%. Because the return is now less relative to interest rates, the the bond’s value may drop. This happens because new bonds will be issued at the higher interest rate.
Interest rates and shares
Depending on the company, higher interest rates could affect them in different ways. Here are some examples:
- The interest rate of loans is affected. If a company wants to borrow money at high interest rates, it will need to pay more.
- Non-essential companies are often negatively affected by spending habits during recessions and times of high interest rates.
- With lower earnings due to lower consumer spending, share prices may drop.
- High interest rates often cause a flight to safer assets. Risky third-world currencies are sold for something more stable or gold is bought as a store of value.
The effect of interest rates on businesses and retail
With higher interest rates, small businesses are often the victim due to larger monthly instalments. It’s a good idea to have a business emergency fund in case something unexpected would happen.
In South Africa, we try to control inflation by upping interest rates. Though this slows down economic growth, it protects the Rand relative to domestic consumer prices.
Interest rates affect more than just your home loan and interest on savings. It affects investments, the stock m market, the greater economy and inflation. Due to the supply and demand of the currency that is manipulated, higher coffee prices and lower stock prices might make you choose one of the two.
Always choose coffee – just joking!