May 2006

Getting interested in interest

Q: What goes up and down, up and down, and has more effect on one's finances than is commonly realised?

A: The interest rate!

Everyone who owes money should be interested in the interest rate, as a change in the interest rate would affect them. There's not one investor who doesn't keenly follow the interest rate trends. Whether you're in debt or in credit, the interest rate will have an impact on your financial situation. For this reason it is imperative that you understand the fundamentals of interest, and the role that interest rates play in the economy.

Centuries ago loans were made in the form of grain and livestock. Since one grain of seed could generate a plant with a multitude of grain seeds, farmers could easily repay the grain with a pre-agreed percentage of "interest" in grain after the harvest.

When farmers bought animals "on credit", the buyer would pay interest by sharing any new animals born with the seller. The Sumerians used the same word – "mas" – for both calves and interest. A similar Egyptian word meant to "give birth". What was loaned had the power of generation, and interest was a sharing of the result.

With loans and interest, both borrower and lender score. The borrower immediately gets the finance that he or she needs, and the lender receives interest in return for meeting that need.

What is "interest"? Here's a simple definition: Interest is the price you pay for the privilege of renting money. The interest rate is the charge you pay for this privilege, expressed as a percentage of the total sum loaned, for a stated period of time (usually one year). To give an example, a rate of interest of 10% per annum means that for every R100 borrowed for one year, the borrower has to pay a charge of R10.

Interest, therefore, is an age-old economic fundamental that recognises that there is a value placed on borrowing and lending capital, or put differently, that money has a time value.

So, how does it all work in practice, and how are interest rates set? At the heart of the entire economic operation of a country is the Central Bank – in South Africa, ours is called the South African Reserve Bank (SARB). The SARB lends money to commercial banks, who then lend it on to their clients. The repo rate is the "price" that the commercial banks pay to the Reserve Bank for the privilege of borrowing money and lending it on to their own clients at a higher price.

For various economic reasons, the SARB increases or decreases the repo rate from time to time. The repo rate is the most important indicator for short-term interest rates. If the repo rate increases, it means the banks need to increase their interest rates, which means that people with overdrafts, for example, will pay more interest. Conversely, if the repo rate decreases, banks will decrease their interest rates.

Interest is arguably the most important factor in your finances. Its impact needs to be considered in all your decisions. Its various forms must be understood, such as the difference between 'nominal' and 'effective' rates of interest, and what is meant by the 'real' rate of return. We'll be discussing these topics in the next few issues of Money Matters.

Bank charges hit the headlines

Money Matters learnt that the Competition Commission has launched an inquiry into banking charges. The Commission released a report at the end of April which showed no apparent link between banks' costs and the fees they charge customers. On the basis of this report, the Commission will be requesting explanations from banks. We will keep you posted.

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