June 2006

What does the interest rate hike mean for you?

South Africans have had an easy interest rate run for the last few years. The nightmare of 1998, when rates soared to 25%, has been put firmly in the past. Interest rates were steadily lowered until 2002, when they were increased four times, and then lowered again until prime stood at 10.5% in 2005 – the lowest in more than two decades.

Now it's back to reality. Interest rates have gone up for the first time in four years. Last month in Money Matters we discussed the repo rate, which is the rate at which the Reserve Bank lends money to commercial banks. On 8 June this year, the Reserve Bank raised the repo rate by half a percentage point, from 7% to 7.5%. This means that banks need to increase their interest rates by half a percentage point as well, and they duly did – the prime lending rate has increased from 10.5% to 11%.

How does the Reserve Bank determine that the repo rate should be increased? The Governor of the Reserve Bank, Tito Mboweni, and his Monetary Policy Committee (MPC) consider various economic factors such as inflation, consumer spending, the strength of the rand, and this time, even the rise in the oil price. The repo rate affects the entire economy, and an increase (or decrease) is necessary to keep the local economy on track.

There's some debate amongst economists about whether the MPC should have increased the rate this time round. But it's pointless debating the issue, because the fact is, the rate has been increased, and that affects everyone with home loans and car loans.

For example, if you are paying off a R100 000 car loan over a 54-month hire-purchase contract, you will now need to pay an extra R25 per month at the new prime rate. (Source: Wesbank). And if you are paying off a R500 000 home loan over 20 years, you will now need to pay an extra R169 per month at the new prime rate. (Source: Standard Bank).

As a consumer with monthly repayments on debt, are you entirely at the mercy of the MPC? Well, yes and no: you can't control when and if interest rates go up, but you can limit the effect on your monthly budget. Here's how:

Say for example your home loan repayment is R4300 per month. That's the minimum the bank requires you to pay. And if you think your bank doesn't care about you, pay any less than that over several months and you'll find out that they know exactly who you are!

But nowhere does it say you have to pay only the minimum. If you pay more than the minimum each month, not only will you pay off your home loan sooner (and therefore save on interest), but you'll also be used to paying more. So, if you've regularly been paying R5000 instead of R4300, and the interest rate goes up and your minimum payment increases from R4300 to R4470, your budget won't notice that extra amount being paid into the bond.

However, to be really wise, you should increase your monthly repayments from say, R5000 to R5200. If you do that, your budget will notice, but you're staying ahead of the game. You will have R200 less to spend on other items each month, but you'll be steadily eating into the outstanding capital on your home loan and thereby reducing the interest burden.

Incidentally, having R200 less to spend is exactly the kind of desired effect that an increase in interest rates has, as reduced consumer spending helps to keep the inflation rate under control. Furthermore, repayment of capital debt, which bears an interest rate of 11% p.a., is tantamount to investing at an attractive tax-free rate of 11%. Put in a different way: Each additional R200 per month repayment will earn (save) R22 per year after tax for you.

But the ideal scenario is to not have any debt at all. If you are debt-free, and you have savings, an increased interest rate would be good news for you. We'll be explaining the positive effect of interest in the next issue of Money Matters.

Click here for previous issues of Money Matters.