EXPLAINER | Who sets interest rates and how do they affect me?

• Interest rates are the percentages at which you pay interest on a loan or earn interest on money you save. The South African Reserve Bank sets a key interest rate known as the repurchase or repo rate, which is increased or decreased to manage inflation and the value of the rand.
• Banks borrow money from depositors and then lend it on to you, the consumer, at interest rates based on the prime rate. The prime rate is based on the repo rate and includes a margin for the bank.
• Banks and other credit providers use your credit history, the value of your loan relative to any security for the loan, such property in the case of a home loan, and your ability to afford the loan to determine an individual interest rate based on the prime rate.
• If you borrow or save money at a variable interest rate, the rate will rise or fall with the repo rate. If you borrow or save money at a fixed rate, this rate will be fixed for the period of the loan at a rate that the lender or bank believes will still be profitable for it based on how interest rates are likely to move in future.
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Interest rates are the rates at which you pay interest on money you borrow or at which you earn interest on money you save. They are expressed as a percentage of the amount you borrow or save.

These rates are influenced by the interest rate a country’s central bank sets and at which it lends money to banks or at which banks can deposit money with the central bank. In South Africa, the central bank is the South African Reserve Bank (SARB).

When the SARB increases or decreases its interest rates, you will hear or read about it in the news generally with a message about whether it will be more expensive or cheaper to borrow.

Soon after the announcement, if you have borrowed money at what is known as a variable interest rate, you will be notified by your bank or other credit provider, that the interest rate has changed.

If you have money saved, you will also be notified – perhaps a little later – that the interest rate you are earning has increased or decreased.

Why does the SARB set interest rates?

The SARB is responsible for controlling inflation through its monetary policy framework. It does this by setting an appropriate interest rate in order to keep inflation low and relatively steady. 

The rate the bank sets is known as the repurchase or repo rate. This is the rate the banks have to pay the SARB when they borrow money from it and the rate they can deposit money with the SARB.

They use this rate to set their own rates to lend to you or to pay you when you save, but you will not pay or be paid the repo rate on what you borrow or save. Banks have costs to cover and will therefore pay you less and charge you more than the repo rate when taking deposits or granting credit.

The SARB increases its interest rate in order to curb inflation as measured by the Consumer Price Index (CPI). It reduces interest rates when inflation is lower than the target inflation rate in order to stimulate the economy.

The SARB’s Monetary Policy Committee meets every two months (in January, March, May, July, September and November) to decide whether to increase, reduce or leave interest rates the same.

It currently has a target to keep inflation between three and six percent.

The committee, with input from the SARB’s economists will consider what is happening in the local and global economy and then determine where to set interest rates given the likely impact on inflation and the economy.  

Rising interest rates:

• Increase the costs for those who have borrowed money at variable interest rates and therefore discourages borrowing and spending. It also promotes saving, because you can earn more on your savings. This in turn, weakens demand for goods and services, the growth of businesses and reduces prices. It can also lead to job losses and this has to be balanced against the negative effects of higher inflation if interest rates are not increased.
• Tend to strengthen the rand’s exchange rate because returns on rand-based investments from foreigners increase so capital flows into the country. A stronger rand reduces the price of imported goods.
• Signals to those selling goods and employers that the SARB is committed to controlling inflation and that they do not need to increase goods and wages and salaries to offset high inflation. Controlling inflation expectations is important as inflation expectations drive wage negotiations in particular.
• Reduce the demand for houses which moderates house prices. This can reduce the wealth of those who own homes, resulting in them buying less and slowing the economy.
• When the SARB is "hawkish", it believes interest rates must rise to curb excess demand and inflation, and when it is "dovish" it believes interest rates must come down to stimulate demand and inflation.

What interest rate do I pay or earn when I borrow or save?

Individual banks can set their own interest rates that they will charge you when you borrow or pay you when you save.

These interest rates will, however, be derived from the repo rate but will typically be higher to cover the banks’ costs, but not more than the rates set in regulations under the National Credit Act.

The prime interest rate is a term used to describe the predominant interest rate at which banks lend to you, the consumer. It is currently the repo rate plus 3.5%.

When you get offered a loan, such as a home loan, it may be at the prime rate, or higher. The lender will consider what the risk you, as a borrower pose, and set the rate accordingly. Banks still need to pay interest on money deposited at the bank even if borrowers do not pay the interest due on what they have been lent.

If, for example, you have a good track record of repaying credit, your income and expenses make it affordable for you to repay a loan and the value of the loan relative to property you are buying is not too high, you are likely to get a good interest rate closer to or at the prime rate.

You will also pay a higher rate if your credit is unsecured – for example, when you are granted a personal loan, overdraft or credit card. 

There are however, maximum interest rates that banks and other credit providers are allowed to charge. Most of these are based on the repo rate.

Fixed or variable rates

Banks and other credit providers charge or pay fixed or variable interest rates. Variable interest rates, also known as floating rates, change with the repo rate, while fixed rates remain the same throughout the life of your loan.

If you borrow or save at a variable rate, it will go up or down whenever the repo rate moves up or down.

Remember, however, that banks fix interest rates at rates higher than the current prime rate based on their expectation of how interest rates are likely to move over the period for which your rate is fixed.

Similarly, if you are offered a fixed interest rate on an investment, it is likely to be set at an interest rate calculated by the bank based on how it expects the repo rate to move.

Do you have any control over interest rates?

Interest rates increase and decrease with the repo rate and you do not have control over that.

You should, however, consider how much interest rates may increase when you take out a loan and make sure you can afford any potential increases as a result of interest rates increases. Do not take a home loan, for example, with a repayment that you will struggle to afford at the current interest rate. Should the repo rate rise and your repayments with it, you may find the repayments unaffordable.

You should also ensure that you have a strong credit record and a good repayment history. If you ever get into any trouble repaying credit, rather negotiate with the credit provider than ignoring the problem.

This article was first published on SmartAboutMoney.co.za, an initiative by the Association for Savings and Investment South Africa (ASISA).