What you need to know: Interest rates

What is an interest rate?

The interest rate is important when it comes to borrowing or saving money. It’s a fee you're charged for borrowing money, for example in a home, car or personal loan; or if you’ve got your money deposited in a savings account or term deposit, it’s the amount you are paid for ‘lending’ the bank your money.

Who determines the interest rate?

The interest rate is set by your bank based on a range of factors; the most important of which is the Reserve Bank of Australia’s (RBA’s) Official Cash Rate.

Why do you pay interest?

Simply put, you pay interest because you’re paying for the ability to use money you don’t have yet. So, interest is an incentive for the bank to lend you money and a premium for the risk they take in lending to you. 

How is interest calculated?

Interest is calculated one of two ways, depending on whether it’s simple or compound interest. Simple interest is calculated as a percentage of your initial amount only, while compound interest is calculated (usually every month) on the entire balance of your savings or loan, including the previous interest payments.

Simple interest

If you’ve put your savings in a term deposit, you’ll earn simple interest. The formula for simple interest is: 

Simple Interest = principal x annual interest rate x years.

Compound Interest

Things like credit cards, home loans and car loans generally work on compound interest. While home and car loans are calculated to be paid off by the end of a predetermined term, credit card interest can compound indefinitely. That’s why it’s a great idea to pay off your credit card balance as soon as you can.

Types of interest rates

There are also a couple of different types of interest rates and they each have their pros and cons. When deciding on an interest rate, it’s important to carefully consider which one is going to be best for your goals, lifestyle and budget. Types of interest rates include:

Variable interest rate

As the name suggests, a variable interest rate can rise and fall over time. Depending on the market and the RBA’s Official Cash Rate, your provider might raise or lower interest rates and those changes will affect the amount of interest you pay or receive.

Pro: Because interest rates may potentially decrease, your repayments may also decrease leaving you more disposable income or the ability to pay off your loan faster.

Con: Because interest rates may potentially increase, your repayments may also increase, leaving you less money to spend on other things, or save.

Fixed interest rate

A fixed interest rate is set at a certain percentage for a specified period of time. Typically, home loan interest rates can be fixed for between one and five years. At the end of the fixed period you can choose to move to a variable rate or ‘re-fix’ your loan for another one to five years.

Pro: For something like a home loan, this might make budgeting a little easier, because you’ll pay the same amount of interest each month. 

Con: Generally, a fixed rate is higher than a variable rate because the bank must manage the risk that the RBA’s Official Cash Rate may increase in the future. This means you might pay more interest on your loan during the fixed period if interest rates remain stable or increase less than expected. So, it’s important to do your research and choose wisely when deciding on a fixed rate loan, because once you’ve locked in a rate, it can be very costly to ‘break’ the loan contract and move to a different type of interest rate.

Comparison rate

The comparison rate is used to help buyers understand what a loan will really cost them. Given as a percentage value, it takes into account other fees and charges in addition to interest rates. This is so that you can more easily compare different options and lenders when choosing a loan. Comparison rates are based on a ‘standard’ loan amount ($150k) and duration (25 years), and don’t necessarily account for all fees. Different terms, fees or other loan amounts might result in a different comparison rate. The comparison rate formula is regulated by the Consumer Credit Code, and all financial institutions and mortgage providers in Australia use the formula.

^* You have to be a Qantas Frequent Flyer member to apply for the Qantas Home Loan. This information has been prepared without considering your objectives, financial situation or needs. You should consider your circumstances before acting on this information.