When applying for a loan in South Africa or anywhere else in the world, a little understanding of important financial terms goes a long way. Therefore, it’s crucial to be familiar with interest rates if you want to save money on your loan.
Most lenders are looking to make a profit through their various loan products. The best thing you can do is to arm yourself with the correct information. This way, you can negotiate the best interest rate for yourself and avoid being taken advantage of.
What exactly is interest?
There are all kinds of loans; personal loans, student loans, car loans, and home loans, to name just a few. One thing these types of loans have in common is interest. As an example, let’s say you borrow R50 000 from the local bank.
You have to pay back all the R50,000 since the bank is not acting as a good Samaritan. This amount you have initially borrowed is called the principal amount. On top of that, you also have to pay interest on the R50,000, so the lender can profit. To sum it up, interest is the price you have to pay for using someone else’s money.
What is the best interest rate for a loan?
According to the National Credit Act, the maximum interest rate in South Africa is currently 27.50% per annum. The best interest rate for your loan is one that you can afford and which gives you maximum savings. That being said, several factors determine what the best interest rate is for your situation:
The loan amount
Remember, this is the principal amount. If you borrow R50,000, you might have to pay more interest than someone who has borrowed R10,000. This is because of two reasons; firstly 27.50% on R50,000 is more than 27.50% on R10,000. Secondly, a large loan may take longer to repay and therefore you end up paying considerably more interest.
The loan term
In the same manner, borrowing money for longer will increase your interest costs. Using a loan of R50 000 with an interest rate of 15% per year, it looks like this:
For 2 years – Total interest is R8,184
For 5 years – Total interest is R21,370
Typically, you pay off your loan by making payments every week, 2 weeks, or once a month. By making weekly or fortnightly repayment, you will pay a little less interest by the end of the loan. This is because interest is calculated daily on the outstanding amount. If you reduce the outstanding amount more frequently, the interest rate you have to pay reduces also. This is particularly important for large loans such as home loans.
Your credit score
A higher credit score gives you better chances of getting a more favourable interest rate. This is because lenders are confident you’ll pay back the money. Hence, they are taking a smaller risk compared to lending money to another client with poor credit. You could potentially halve your interest rate by looking after your credit score.
When you apply for a loan, lenders will tell you the interest rate as a percentage. The basic formula to calculate interest using the rate of interest looks something like this:
Example: For a R50,000 loan taken at an annual interest rate of 15% over 60 months (5 years), interest for the FIRST month is calculated as follows:
[0.15 ÷ 12] × 50,000 = R625
With each monthly payment, you are reducing the balance on the loan. Let’s say, after five months, you are left with paying off R44,055 only. That means the interest you pay for that month is as follows:
[0.15 ÷ 12] × 44,055 = R551
As you can see, the interest rate remains the same, but the interest payment is now lower. This adjustment is made until you finish paying off the loan. So, if you’re now left with only R7,134 to pay off, the interest will be:
[0.15 ÷ 12] × 7,134 = R89
If you don’t want the hassle of calculating interest payments, most lenders do it for you. In addition, you can also use a simple interest calculator to get an idea of what to expect before applying for a loan.
How are interest payments made?
When you pay back your loan, you do it in instalments. These instalments include the interest and the money that goes towards paying off the loan. To explain this, we will use the same example given above.
Example: For a R50,000 loan taken at 15% interest per annum over 60 months, the monthly repayment will be an estimated R1,189.
For your first instalment, the interest will be R625 (as calculated in the previous section). The remainder, which is 1,189 – 625 = R564, goes towards paying off your loan. This means you have reduced your loan balance from R50,000 to R49,436.
When it has been reduced to around R40,488, interest will now be R506 (as calculated in the previous section). The R506 is again deducted from your monthly instalment, and the remainder, which is R683, goes towards paying off your principal. The loan balance then moves down from R40,488 to R39,805.
By the time your loan balance is at R7,134, you only have to pay R89 in interest. This gets subtracted from the monthly instalment. 1,189 – 89 = R1,100, and this reduces your loan balance from R7,134 to R6,034 and so on until the whole amount is paid off.
Calculate interest on your credit card
When you use your credit card, you also pay back interest because you’re using money that doesn’t belong to you. Credit cards have minimum monthly payments, but paying only the minimum on your credit card is not a good idea.
This is because minimum repayments barely reduce your balance, as most of it goes towards interest. Generally, credit cards in South Africa have higher interest rates ranging from 20% to 25%, and this can lead to massive debt. Hence, you will always save more when you pay off your credit card debt quickly.
Knowing about interest rates calculation empowers you to make wise decisions when taking out and paying off a loan.
You may also find our personal loan repayment calculator useful. It provides an estimate of your monthly repayments for South Africa’s top lenders, with monthly and initiation fees (which we didn’t have a chance to cover in this blog) figures included in the calculation. However, we must stress that these are estimates based on the lender’s advertised interest rates. As we discussed earlier, your credit rating can significantly impact the rate you receive, when applying for a loan.