# Interest rates explained

**Interest Rates Explained**

In Australia, mortgage and home loan interest rates are never far from the headlines, and rightfully so. The family home being one of the largest purchases we make, means, if you are a potential home owner or mortgage holder, then rates are going to have a large effect on the finances in your life . Let’s take a closer look at what they are all about.

**What is Interest?**

Interest is a fee paid on borrowed capital – you could say that it is “rent on money”. The fee is compensation to the lender for giving up other useful investments that could have been made with the loaned money or principal amount.

**What is the ‘Principle’?**

The amount of money loaned to the borrower is called the principal. Interest is paid on the principal at a reducing interest rate.

**What is a ‘Reducing Interest Rate’?**

As opposed to a flat rate, a reducing rate means that the interest charge is calculated against the principal amount outstanding. This means that as the principal is paid off, the interest charge reduces. For example:

$500,000 loan at 10%

The annual interest payable is 10% of $500,000 = $50,000

The daily interest charge is then $50,000 / 365 days = $137

For every day that there is $500,000 owing there will be interest payable of $137. However, if the principal amount is reduced to $400,000, then the interest charged annually reduces to $40,000 and the daily charge is $109. As the principal reduces, so does the interest charge.

In this case making extra repayments can help reduce the total cost of the loan. For example, by using the additional payment calculator for a loan of $500,000 at 10% over 30 years, you can see that simply making an extra payment of $20 each month (a total of $7200) saves you over $36,000.

Cheaper rates are not always the cheapest

Be aware: one lender may offer a cheaper home loan rate compared to other lenders, but is it really the cheapest?

It pays to calculate the total cost of the loan, because by the time you add in fees and charges over the term of the loan it may not be cheaper at all. You should also consider the features or benefits the particular loan offers that may be worth trading off over the interest rate. A handy tool here is the Comparison Rate.

**What is the Comparison Rate**

The comparison rate is a tool to help prospective borrowers identify the true cost of a loan. It is a rate which includes both the interest rate and fees and charges relating to a loan, reduced to a single percentage figure. However, it doesn’t take into account extras like exit fees or redraw fees.

**Who sets mortgage interest rates?**

You might immediately think of the bank or lender as being the one who sets the interest rate, but this is only partly true.

There is also a cost to the banks for the money they obtain to then on-lend to borrowers. This cost comes from the interest rate the bank pays to a depositor or the cost of money that they obtain in the ‘money market’. The money market is where the Reserve Bank of Australia (RBA) acts to set what is called the Cash Rate.

**What is the Cash Rate?**

The cash rate is the interest rate charged on overnight loans between financial intermediaries (e.g banks) often referred to as the money market. As the RBA writes – It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built. The RBA ‘controls’ this cash rate as a tool for achieving Monetary Policy outcomes. More about the RBA and Interest Rates

source: mortgageseek