Should you fix your interest rate, now at a historic 50-year low?

Interest rates are a fundamental economic factor which affect the performance of the financial markets and to a large extent, impact the interaction between lenders and borrowers.

In South Africa, the interest rates decisions are taken by the South African Reserve Bank's Monetary Policy Committee (MPC). The official interest rate is the repo rate. This is the rate at which central banks lend or discount eligible paper for deposit money banks, typically shown on an end-of-period basis. Last month, The South African Reserve Bank slashed the repo rate for the fifth time this year, bringing borrowing costs to the lowest level on record, amid the coronavirus crisis.

For consumers, understanding interest rates, knowing what drives these rates and whether this is the ideal time to fix interest rates becomes imperative.

What is an interest rate?

The interest rate is the amount a lender charges for the use of assets expressed as a percentage of the principal. The interest rate is typically noted on an annual basis known as the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, or large assets such as a vehicle or building.

When are interest rates applied?

Interest rates apply to most lending or borrowing transactions. Individuals borrow money to purchase homes, fund projects, launch or fund businesses, or pay for college tuition. Businesses take loans to fund capital projects and expand their operations by purchasing fixed and long-term assets such as land, buildings, and machinery. Borrowed money is repaid either in a lump sum by a pre-determined date or in periodic instalments.

What are the factors influencing market interest rates?

- Deferred consumption: When money is loaned, the lender delays spending the money on consumption goods. According to time preference theory, people prefer goods now to goods later. In a free market there will be a positive interest rate.

- Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. If the inflationary expectation goes up, then so does the market interest rate and vice versa.

- Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, boosting the market interest rate.

- Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail. The greater the risk is, the higher the market interest rate will become.

- Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. If people are willing to hold more money in hand for convenience, the money supply will contract, increasing the market interest rate.

What are the types of interest rates consumers should know?

1. Fixed interest

A fixed interest rate is as exactly as it sounds - a specific, fixed interest tied to a loan or a line of credit that must be repaid, along with the principal. A fixed rate is the most common form of interest for consumers, as they are easy to calculate, easy to understand and stable.

2. Variable interest

Interest rates can fluctuate too and that's exactly what can happen with variable interest rates. Variable interest is usually tied to the ongoing movement of base interest rates (like the so-called "prime interest rate" that lenders use to set their interest rates.) Borrowers can benefit if a loan is set up using variable rates, and the prime interest rate declines (usually in tougher economic times.)

3. Annual percentage rate (APR)

The annual percentage rate is the amount of your total interest expressed annually on the total cost of the loan. Credit card companies often use APR to set interest rates when consumers agree to carry a balance on their credit card account. APR is calculated fairly simply - it's the prime rate plus the margin the bank or lender charges the consumer. The result is the annual percentage rate.

4. Simple interest

The term simple interest is a rate banks commonly use to calculate the interest rate they charge borrowers (compound interest is the other common form of interest rate calculation used by lenders.)

5. Compound interest

Banks often use compound interest to calculate bank rates. In essence, compound rates are calculated on the two key components of a loan - principal and interest. With compound interest, the loan interest is calculated on an annual basis. Lenders include that interest amount to the loan balance, and use that amount in calculating the following year's interest payments on a loan, or what accountants call "interest on the interest" of a loan or credit account balance.

Does the current historic low interest rate present a fixing opportunity for consumers?

With lower rates, those that do have to pay off loans to the bank are undoubtedly better off and certainly many would like to use this windfall to their advantage. That is the reason why many are considering 'fixing' the interest rates on their loans.

Most South African banks are currently prepared to fix the rate of their clients' mortgage loans at a certain level. In the current environment of low-ish interest rates it may make sense for borrowers to consider fixing their mortgage rates.

Typically, when an interest rate is "fixed," it will be for a limited period of one to five years. This implies that when a rate is fixed, it is usually fixed between 150 to 300 basis points - that is 1.5% to 3% - higher than the current rate a client is paying. That means that short-term interest rates will have to fall by an additional 150 to 300 basis points or more, and rather soon, for a client to break-even should he/she decide to fix his/her rates.

So, the question to fix or not to fix depends on the level and the duration at which you can fix the rates. You first have to confirm with your bank which fixed rate it will offer, and for how long. Typically, banks will fix a home-loan rate for a maximum of five years.

Fixed rates offered by the bank vary on a regular basis, and depend on a number of factors, including the outlook of the bank on the future movement of interest rates. Customers, therefore, cannot choose which rate to fix at, but can ask to be quoted on the rates available at any given time, and select whether to fix at the offered rate then, or not.

Also, the longer you want to fix the rate for, the higher the rate on offer will be.

The downside, however is that "locking yourself into a fixed rate for say three or five years, is that there is a chance that interest rates could remain low or fall even further over that time, leaving you paying more than you otherwise would have.

Article Courtesy Private Property