With words like variable, fixed, prime, compound and comparison, the subject of interest rates isn’t just interesting – it’s downright fascinating…and perhaps a little confusing too.
Understanding interest rates and making them work for you is equal parts art and science. Mastering the subject won’t just make you seem smart at dinner parties (though it’ll do this too), it could also save you significant cash in the long-run – a goal we can all get behind.
Interest is generally divided into two categories – ‘interest earned’ and ‘interest paid’. Simply put, interest either rewards you with money (for saving) or costs you money (for borrowing). Let’s dig into these categories a little deeper.
Here we explore two ways you can earn interest:
1. through a savings account such as the ANZ Online Saver, for example, which gives you flexibility to access your savings at any time while still earning interest on your deposits.
2. through a term deposit, which on the other hand, rewards you with a known rate of interest for a set term (12 months, say) that you determine in advance – though fees and charges apply to early withdrawals.
When it comes to paying interest, credit cards and home loans are the most commonly thought-of accounts that charge interest for lending you money. Student, car, personal and business loans are other common accounts where you pay interest to borrow money.
The Reserve Bank of Australia
Interest rates in Australia are based on the Reserve Bank of Australia (RBA)’s official cash rate. Each night, banks lend and borrow money from each other in a market known as the ‘cash market’. The cash rate is the interest rate earned or paid on these loans – a target set by the RBA. But while the RBA determines the cash rate target, each bank sets their own interest rate. Meaning? The amount of interest you pay on your loan or earn on your savings will vary between providers, so it pays to do your research.
Interest suitably piqued? Then let’s explore some common types of interest.
Different types of interest
There are two ways interest can be applied to your bank account – via simple interest or compound interest.
1. Simple interest is just that – simple. It’s paid at an agreed frequency, and you only earn interest on your initial savings deposit, meaning interest isn’t added to the closing balance of the account. When it comes to paying simple interest, it’s charged as a percentage of your original loan amount or principal (the total amount borrowed).
2. Compound interest accounts, on the other hand, have a snowball effect on your savings, because you’re earning interest on both your initial deposit AND any interest you’ve accrued since opening your account. Your money snowballs exponentially, so you’re essentially earning interest on your interest.
When it comes to paying compound interest, however, interest accrues each month based on the total value of your loan, including interest you’ve already paid. Home loans mostly use compound interest, which is why it’s often a smart idea to pay down the balance as quickly as you can.
How interest rates work
Fixed interest rates
Fixed interest rates are set up-front and remain consistent over either the entire period of your loan, or a set period of time (usually between one and five years). The advantage of a fixed rate is that you aren’t subject to fluctuations in interest rates set by the RBA, which can help you ride out periods of high interest unscathed. You also know in advance exactly what your loan repayments will be each month, so you can budget accordingly.
On the flip side, if the interest rate drops, you’ll continue paying the fixed rate previously agreed upon, and there can be limits to how much you can pay back in a year. If you prefer to know exactly what you’re up for, then fixed interest rates could be for you.
Variable interest rates
Variable home loan rates can change depending on interest rate changes, so your repayments could vary. Sometimes you’ll benefit when rates drop and sometimes your rate could go up, costing you extra money on your repayments. A variable rate account can offer more flexibility than a fixed rate account, as you typically have access to your money at any time. However, this flexibility comes with a price. Variable rates are often higher than fixed rates, but they also often come with home loans with other benefits like offset accounts and wealth packages. It’s always good to do your research before making a decision. Or you could consider splitting the loan between fixed and variable to get the best of both.
Tiered interest rates
With a tiered rate, you earn different rates of interest depending on the balance of your account. Tiered rate accounts provide a great incentive to reach a set savings goal, because once your account balance exceeds a certain amount, they pay a higher rate of interest on the whole balance. ANZ Access Advantage and ANZ Premium Cash Management Account are examples of accounts where the interest rate is tiered.
Banded interest rates
With banded interest rates, different rates of interest apply to different parts of your account balance. For example, the interest paid on the first $9,999 of your balance may be different from the interest paid on the part of your balance between $10,000 and $20,000.
When comparing the rates on different loans, it pays to look at the comparison rate – which is what the loan is really going to cost you. Instead of just comparing interest rates, the comparison rate also takes into account fees charged by the bank (annual fees, for example), producing a percentage value that allows you to compare the monthly repayments on your loan with far greater accuracy.
Credit card interest
When you put a purchase on your credit card, you’re essentially borrowing money that you don’t actually hold from a financial institution. The bank charges you a fee for the benefit of loaning the money – that’s interest! But the amount you pay isn’t set in stone. It depends on the specific card you have, when you make your repayments and how much you pay back. And keep in mind, credit cards charge compound interest, so you’ll want to pay off your balance pronto.
Do you find interest rates fascinating now? Perhaps not, but understanding them can reap some financial dividends right now and into the future.