Knowing what an interest rate is and how it works is one of the most important pieces of knowledge a potential borrower needs.
Interest is the price a borrower pays to borrow money from a lender. It can also be the amount that is earned on deposited funds in an account such as a savings account. Lenders who charge interest are essentially placing a leasing charge on an asset’s use. When talking about loans, the asset is money, so it’s important to understand the ins and outs of interest rates.
Interest rate basics: What does p.a. mean?
P.a. literally means per annum, or every year. When interest is expressed as a percentage followed by the term p.a., it means that the rate you are looking at is the yearly rate. The p.a. rate can either be calculated at the end of the year, or compounded as often as each month. More on the difference between simple interest and compound interest is covered in the savings account section below.
Credit card interest
Credit cards can have varying interest rates. You will be able to find cards with around 13% interest on the lower end of the spectrum and cards with upwards of 20% interest on the higher end of the spectrum. These rates are calculated daily and applied monthly to any charges you make. This does not mean that you will always be paying interest on all of your purchases though, as there a few ways to avoid it.
One way is through the introductory rates which are often offered on credit cards. With an introductory rate you are receiving a very low interest rate for a set period of time after the activation of the card.
Paying off the full closing balance of your statement each month by the payment due date is another way to avoid interest charges. If there’s no balance, you can’t be charged interest.
Interest free days are a very handy feature usually offered with credit cards which allows you to pay off your purchases before the due date. Many cards will offer an interest free period on purchases. For example, if you charge $200 on your credit card at the start of your statement cycle and the card has 55 interest free days, you will have 55 days to pay off the balance. When comparing credit cards make sure to see how many interest free days are offered on purchases, as you can save a lot of money in the long term by taking advantage of them.
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Loan interest rates
The interest rate that must be paid on a home or personal loan has a lot to do with the cash interest rate set by the Reserve Bank of Australia. This rate is renewed every month and lenders base their rates off of this.
You can choose to pay a variable interest rate on your home or personal loan. This type of interest rate is very closely tied to the cash rate and can be a bit unstable. The benefit of a variable rate is that they usually go down if the Reserve Bank of Australia decides to lower the official cash rate. Also, restrictions on the number of repayments you can make in a certain amount of time are usually looser with variable rates of interest. Be wary though, if the cash rate goes up, your variable interest rate will too.
Fixed rates when applied to personal loans or home loans are a good safeguard against future rises in interest rates across the board. You can lock in your interest rate for a period of 1 to 5 years in general. You won’t benefit from falling interest rates, but you also won’t have to worry about skyrocketing interest rates also. There are usually ways to refinance your loan to a lower fixed interest rate, but you may have to pay a fee.
Split interest rates let you pay a fixed rate on a portion of your home or personal loan and a variable rate on the rest. This type of interest structure is good for borrowers who want the security of regular and unchanging payments on part of their loan, with the flexibility offered by variable interest rates on the other part of their loan. The fixed portion of the loan is usually more restrictive in terms of repayment options, but as mentioned it won’t fluctuate like the variable portion.
Lenders by law must provide comparison rates in order to make the loan comparison process much easier for customers. It’s normally fairly difficult to compare two loans that have differing fees and interest rates, so a comparison rate attempts to provide a top down overview of the average rate when fees and charges are taken into account.
For example, if a loan has an 8% interest rate, but fees and charges total 1% of the total cost of the loan, the comparison rate will be 9%. Whereas a loan that has a 8.25% interest rate and .5% total fees and charges will have its comparison rate calculated as 8.75%. Therefore, a loan with a lower interest rate will not always be better than one with a higher interest rate. It’s important to use the comparison rate to get a better picture of how much you will actually have to be repaying on the loan.
Keep in mind that a comparison rate for home loans is always calculated with the same loan terms: $150,000 borrowed over 25 years. This means that the rate might not always be as accurate if your loan amount of term deviates from this, so keep this in mind when using comparison rates.
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Savings account interest rates
With savings accounts you earn interest on the money you have deposited. An interest rate can be calculated and paid out on a yearly basis, or compounded as often as every month. When depositing money, you will want to try and get a compounding interest rate. Here is an example of the difference between the two types of interest calculation and how they impact your bottom line:
The difference between simple and compound interest
Simple interest is paid only on the money you have deposited into your account and not the earnings of said account. If your savings are earning a simple, or nominal, interest rate, there is no reason to have it compounded. If you deposit $10,000 into a savings account with a 6% p.a., you will earn $600 per annum on interest.
Compound interest means that the interest earned on your savings is added to your balance on a regular basis. Not only does your money earn interest, but your interest earns interest as well. If you have an interest rate of 6% on 10,000 dollars in deposits and it’s compounded monthly, you will earn approximately $617 in interest over the course of a year. This is because each month, the interest is calculated on the balance plus the interest earned the month before.
Bonus rates for savings accounts
Bonus interest rates for savings accounts are higher than normal rates. Banks and other financial institutions offer bonus interest rates for a variety of reasons. You may find that a bank offers bonus rates to customers with multiple banking accounts, students or for people who use certain financial products or features that the bank offers. Always look into the potential bonus rates you can earn with each bank, as you can end up earning a lot more money in the long run with a higher rate on your savings.
Compare savings accounts
Knowing how interest works will increase your ability to compare financial products. Get familiar with it and how it’s applied to your account, whether you’re being charged interest or earning it.