“If you understand interest, you will earn it. If you don’t, you will pay it.”
– Albert Einstein
I think that most people know there will be interest charged when they lend money. The thing that most don’t know… is that the amount they are charged is a moving target and can increase without their control.
You may have heard recently in the news that interest rates are increasing and it is critical you understand how this affects your pocket.
In South Africa, the Prime Lending rate is the average rate of interest charged on loans by the banks, lenders and retail stores. When you take out a loan this rate is used to calculate how much you will need to pay back.
As of Thursday, 28 Jan 2016, the Prime Lending rate is 10,25%. So if you decided to buy a car the finance company would calculate how much interest you will pay by scoring your credibility as a payer and add it to the prime interest rate. Here’s how it works:
Let’s say you’re a good payer according to your credit profile so they may decide to give you an interest rate of ‘Prime minus 1%’. This means you’d pay 10,25% less 1% so your interest on the car finance purchase would be 9,25%. And if your credit record shows you’re quite indebted and don’t pay your loans consistently? Well then they may score you badly and give you a lending rate of ‘Prime plus 2,5%’ meaning you would pay 10,25% plus 2,5%.
This means the good payer could end up paying 3,5% less interest than the bad payer. Same car, just more expensive. (Having a good credit record is another area where good money managers score.)
Whilst this may seem interesting, here’s the real lesson (risk) you need to understand about the Prime Lending rate. I’m writing this article on 29th January 2015 and since January 2014, the Prime Lending rate has increased by 1,75%. Within a year, whatever interest you were paying has increased by this amount and is much scarier than it sounds! Take a look at this:
A year ago if you had a homeloan of R800,000 and you were paying 8% interest your monthly repayments would have been R6,691.52 per month. Just 1 year later, the interest on your homeloan would have risen to 9,75% with a monthly repayment amount of R7,588.13. This is an increase in living expenses of R896,61. And the scary thing, you are not paying off your house any faster, you are just paying more interest.
And if this is not alarming enough, towards the end of 2008 the Prime Lending rate was at 15% which would mean your monthly installment would cost you R10,239.98. This is an escalation in your living costs from the day you bought the house of R3,548.46 per month!
In 2009 there were 3,000 homes and 5,000 cars being repossessed a month simply because most people have a relatively fixed income and these sudden increase in costs caused chaos at home.
What to do?
We are in an interest rate hike cycle which means the Prime Lending rate is probably going to increase over the next year or two. Hopefully this will not be too similar to 2008, but you must anticipate this, or you could be pushed into a financial corner.
My advice to you:
- Be proactive and get your house in order. Sit down with your family and go through your expenses and cut down where you can.
- If you have any debt start paying it off as aggressively as you can.
- Do not take on any more debt!
- Do not take on any more debt! (Just in case you missed point 3)
- Set up an emergency fund to make sure you have some extra money to cover any surprises so that you don’t need to lean on acquiring more debt.
- Pay extra money into your homeloan. Not only will this kill interest but will also mean you have some extra money available to cover your homeloan payments if interest rates rise sharply.
The bottom line? Your money does need a strategy. And, what I’ve shared with you, is the way that wealthy people understand the current economic climate and make sure they take specific steps to protect their homes and other assets as well as their peace of mind for their families. Now is the time to be smart and take action!
Author: Gary Kale, Money Coach