UNDERSTANDING THE MECHANICS OF THE INTEREST RATE

The South African Reserve Bank (SARB) recently reduced the repurchase rate (repo rate) to 3.5%. This follows a series of reductions aimed at easing the financial pressures faced by South Africans and improving the country’s economic outlook in the wake of the COVID-19 pandemic. Consequently, the prime lending rate has reduced from to 7%. With interest rates being at their lowest in over 40 years, many have encouraged consumers to purchase property of the back of the low interest rates and potentially lower property prices as many homeowners struggling to keep up with costs look to sell (a buyers’ market to use a popular phrase).

This of course can be either good or bad and one needs to take into account their personal circumstances to see if it works, as it is not a one size fits all situation, despite what commentators and ‘influencers’ say – it can go horribly wrong. In order to be a success the interest rate (cost of funding), must not only be low but remain low for a long time and the purchase price of the property (asset cost) must be at a significant discount. Interest rates will inevitably increase and the higher the cost of the asset, the less the consumer will be protected from such increases, quickly turning what seemed like a good idea into a horrible and unaffordable nightmare – there will be no marketers and ‘influencers’ in sight to help you out of this one. Besides any property purchase should not be influenced just by low rates but all the ‘Property Investment Principles’ (See: https://propertylink.africa/the-property-investment-principles/).

Perhaps it is worth the effort to take a bit of time and understand the mechanics of the interest rate and specifically how the interest rate in calculated by banks.

The repo rate for starters is the rate at which the SARB or any central bank lends money to commercial banks for short-term funding. Short-term funding is funding that typically does not exceed a period of 12 months.

The prime lending rate is the base rate (starting point) at which commercial banks lend money to consumers. Commercial banks do not lend at the repo rate because (well) banks are a business and as such have operational costs associated with the business including, salaries, offices, equipment, tech etc. and more importantly they take a risk on consumers by loaning money (which may not be repaid) and for that they charge a margin (broadly referred to as interest) on the repo rate in order to compensate themselves for operating a business and taking the risk of lending money to consumers.    

Any change in the repo rate will therefore affect consumers who have opted for the variable rate on their mortgage bond repayments. Consumers with a fixed rate will not be impacted at least for 5 years, after which they will need to select whether to continue with a repriced fixed rate or a variable rate.

Importantly though, how does this affect the interest rate that your bank has provided to you. Interestingly not so much. Banks price risk on individuals, loosely: what is the probability of the bank being repaid or not being repaid and what how much is the bank willing to price for that risk. In pricing that risk, banks use a number of criteria including:

  • cost of funding
  • affordability
  • credit profile
  • collateral      

Strictly speaking a banks cost of funding is not determined by the repo rate, but by prevailing market conditions at the time of obtaining the loan, such the level of liquidity in the market. The bank’s cost of funding is determined by deposit rates, the cost of foreign funding (if any) and the cost of capital. The repo rate should, therefore, not be seen as a proxy for average funding cost of banks. So the better the market generally, the cheaper the cost of funding.

Determining your affordability is extremely important, so look carefully at your financial situation and ensure that your income way exceeds your liabilities, simply because the less burdened you are the less likely you are to default and lesser of a risk. This means you will be ‘priced better’ than someone who is more burdened and likely to default and potentially costing the bank more money in collecting. Also giving yourself a bit of breathing room is important, in these times more and more South Africans are failing to meet their debt obligations (See: https://businesstech.co.za/news/finance/410115/south-africans-are-now-missing-payments-and-defaulting-on-loans/).

Your credit profile helps banks to determine your creditworthiness by setting out how much debt you have, the balance of outstanding amounts and your repayment history. It is never a good idea, Thandi, to skip that cellphone or Truworths repayment for a girls night out as it will also show on your credit report whether you have any defaults or judgments obtained against you. The bank will use this information on whether to provide you with a loan for starters and if so what the risk will be. It is therefore always important to check your credit profile and ensure that it is correct at all times (See: https://www.transunion.co.za/archives-article/all-you-wanted-to-know-about-credit-reports-but-were-too-afraid-to-ask).  

Being able to provide collateral can improve the chances of you obtaining a home loan and influence the rate some banks will provide you. Collateral includes having someone stand as surety, having other assets that the bank can ‘take’ if you are unable to meet your repayments obligations. This could include ceding investment account proceeds to the bank or offering other properties as security. It’s even better when the value of your collateral exceeds the cost of the amount outstanding to the bank, your risk rating profile becomes very low.

So even though the reduction in the repo rate and consequently the prime rate is extremely important and affects the repayments on your home loan, these are not ‘major’ determining factors in the bank ultimately deciding on whether to provide you with a home loan and the interest rate you ultimately be provided. Understanding the above factors will assist you greatly in being able to obtain a better rate for your home loan.  

*Disclaimer: The contents of this article should not be considered as legal, professional, financial or any other form of advice. These are merely views based on the writer’s personal experience. Readers should obtain independent advice on any matter prior to making any decision.

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