What you need to know about interest rates to make sure you're getting the best deal.
A number of different financial products come with interest rates: personal loans, home loans, credit cards and savings accounts. Some types of interest rates cost you money and some earn you money. For example, your savings account interest rate will earn you money whereas your credit card interest rate will cost you money. Interest rates can be structured and charged in different ways depending on the bank and the product. It's important to know how interest rates work so you know how to compare products and find the right one for you, so this guide will take you through what you need to know.
First, what does p.a. mean?
You see "p.a." after the percentage symbol in an interest rate. It stands for "per annum" and means the rate is an annual rate. With financial products, annual interest is calculated regularly (usually daily) as you make regular repayments to a loan or put more money into your savings account.
What is the comparison rate?
The comparison rate is a representative rate that includes both the interest rate and fees. It's useful to look at the comparison rate when considering products as it shows you the true cost of the loan, not just the rate or the fees separately.
What are the different types of interest rates?
There are two main types of interest rates, fixed and variable:
- Fixed interest rates. This is a set interest rate that is essentially "locked" for the duration of your loan term. The rate you agree to in your loan contract is guaranteed to remain in place until you close the loan out at the end of the term.
- Variable interest rates. This is a rate that may change during your loan term. This may be more likely for some products than for others. For example, personal loans can come with variable interest rates but it is unlikely for the rate to change during the loan term while it's much more likely a home loan with a variable rate will change.
How is interest charged on different financial products?
Interest works very differently depending on the type of product you have:
Credit cards come with variable, annual interest rates. The rates vary a lot depending on what features the card offers, but you can generally find a basic, no-frills credit card for between 8-13% p.a. while a rewards or feature-packed card can set you back between 17-22% p.a.
You will find two types of interest rates on a credit card: purchase rate and cash advance rate. The purchase rate is what you're charged to make purchases on the card and the cash advance rate is what you're charged to withdraw cash using the credit card. Credit cards can also offer special interest rates such as introductory 0% rates or balance transfer rates.
Another interest rate-related feature of credit cards is interest-free days. This refers to the period of time between making a purchase and when you will be charged interest on that purchase. If you pay off your credit card balance during this period, you will not be charged interest. Most credit cards offer 55 interest-free days.
Interest rates on personal loans can be fixed or variable and are annual rates. These rates used to very much reflect the market, specifically the cash rate, but recently lenders have been moving towards personalising interest rates based on how risky it is to offer you the loan.
This is why there are now two types of interest rates you will see advertised for personal loans: set rates and risk-based rates. Set rates will be given to everyone who is approved for a personal loan for that lender. Lenders offerings risk-based interest rates will be advertised using a range, for example, 7% - 18% p.a., and you can be approved for an interest rate between that range. Usually, you can get an estimate of the rate you will receive before you fully apply for a loan and without it affecting your credit score.
Home loan interest rates can also be fixed or variable. Fixed interest rates are guaranteed not to change whereas variable rates may fluctuate. With home loans, fixed interest rates usually only apply for the initial stage of a loan, for example five years. Variable home loan interest rates can change quite frequently as they are heavily influenced by factors in the market, especially the RBA Cash Rate. The interest you are charged will generally be calculated daily. Home loans can also either be principal and interest, meaning you're repaying both the interest you're being charged and the original amount you borrowed, or interest-only, so you are only repaying the interest accruing on your debt.
Savings accounts work differently from credit accounts because the interest rates earn you money rather than cost you money. All savings accounts come with a variable base rate, with most calculated daily on your principal balance and paid into your account monthly. This is referred to as compound interest: the interest repayments you earn then go on to earn interest themselves.
Some savings accounts can also offer you bonus interest on top of the standard base variable rate which may be for an introductory period, such as for the first three months after opening the account, or applied monthly if you meet certain conditions, such as regularly depositing money into the account.
How should you compare interest rates?
Keep the following in mind when comparing interest rates:
- The actual rate. Look at how competitive the interest rate is when comparing. While the cheapest isn't necessarily the best, a better interest rate can do a lot to save you money in the long run.
- The comparison rate. The comparison rate includes both the interest rate and any upfront and ongoing fees. It is more representative of the true cost of the loan and can give you a good idea of how competitive it is overall, so it useful to compare.
- Like-for-like. While comparing interest rates across products is a good idea, make sure the products you are comparing are similar. For example, you might compare one credit card to another one with a much lower interest rate but it doesn't mean it comes with the same features. See what features and benefits the products offer and ensure you are comparing similarly-featured products.