Do interest rates really matter when settling debt?

As the interest rate fluctuates, you may have wondered what impact this has on your outstanding debt. How much more or how much less will you pay as a result?

We decided to see what local financial experts had to say about this. We look at how interest rates impact different kinds of debt, and why interest rates fluctuate in the first place.

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Two kinds of debt to consider

According to Ariel Eliasov, head of Credit, FNB Loans, the fluctuation of the interest rate has a different impact on different types of debt.

He explains that there are two main categories of debt that need to be considered, including debt with a fixed interest rate, and debt with an interest rate that is linked to the prime interest rate.

“If you have taken out debt with a fixed interest rate, such as in the case of some personal loans, your monthly repayments will remain unchanged. Knowing that your interest rate won’t change can go a long way in helping you budget month-to-month,” says Eliasov.

However, he says that if the interest rate of your debt is linked to the prime interest rate, the change in the repo rate will directly impact your monthly instalment.

“To illustrate, an instalment on a R1 million home loan paid back over 20 years, would be R8,433.40 when the interest rate is 8%. Should the interest rate drop to 7%, the instalment reduces to R7,821.99. On the other hand, if the rate increased to 9%, the instalment would increase to R9,066.26,” says Eliasov.

Repo rate versus prime lending rate

According to Sheila-Ann Robey, financial adviser at Lifeguards, an affiliate of Liberty, a distinction must be made between the repo rate and prime lending rate.

“The repo rate is the interest rate commercial banks pay to borrow money from the South African Reserve Bank and, by lowering or raising this, the Reserve Bank effectively makes it more or less expensive for commercial banks to borrow money and, in turn, affects how affordably they can lend money to individuals,” says Robey.

She explains that the repo rate drives the prime lending rate. The prime lending rate is a rate used by banks to calculate interest rates for specific clients based on their risk profile. The higher the risk, the higher the interest rate on the loan.

“If the repo rate goes up, then the prime lending rate goes up and individuals will pay more on their debt, and inversely if the rates go down,” says Robey.

What causes interest rates to fluctuate?

According to Eliasov, when you sign up for credit, the bank will indicate the interest rate related to your credit product.

“If this interest rate is linked to the prime interest rate, and the repo rate is changed by the South African Reserve Bank (SARB), you can expect a change in the interest rate applicable to the credit product that you hold,” says Eliasov.

“An increase in the rate will result in an increase in your monthly instalments and a decrease will lessen your monthly instalments,” he adds.

Penalties not applicable for paying more

Eliasov points out that, in terms of the National Credit Act, banks cannot charge any penalties for paying additional amounts into your loan, and the bank must reduce the interest charged to you accordingly if you do this.

He explains that a reduction in your interest rate gives you the opportunity to truly make wise money management decisions. He highlights the following ideas:

• Keep paying the higher instalment that you have become used to – in doing so you will pay off your debt faster, saving on interest and fees and your overall cost of credit.
• You could also use the money that you saved on a particular instalment to pay towards your credit agreement with the highest interest rate to ensure that you save the most interest.

“If you are unsure, review your credit agreement to see which rate type is applicable to your loan or credit facility,” says Eliasov.

What can you do as a consumer?

Robey says that, as an individual, it may feel as though there is very little within your control. However, she adds that you can control how you spend and have fluctuations in the interest rate work for you.

“When interest rates are lowered, it is advisable that individuals use the opportunity to maintain their repayments as though the interests had remained the same, thereby reducing their total interest and shortening the loan repayment term,” says Robey.

“It may be tempting to spend more as cash becomes available as a result of a lowered interest rate, but you need to be aware that just as quickly as current interest rates have been cut, they could be increased and affect your affordability in the long run,” she cautions.

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