Interest and interest rates explained

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You may hear the terms ‘interest’ and ‘interest rate’ thrown around a lot, but have you ever actually been told what they mean and how they work?

Now is the time to get your head around these confusing but important terms. It’s a little dull, but it’s helpful to understand – so you’ll thank us later!

What is interest?

Interest is the sum of money (built up over time) that you either gain from a financial institution for holding your savings with them, or pay as a fee to a lender in addition to an amount you’ve borrowed

There are two main types of interest: simple interest and compound interest.

Simple interest involves gaining or paying interest on the initial amount borrowed or saved.

Compound interest involves earning interest on your interest. Now let’s break this down.

  • If you have compound interest on a savings account, you will gain interest on both your original savings deposit AND the interest you’ve gained from the bank.
  • If your loan or credit card account uses compound interest, you will ultimately have to pay more interest as it is charged on your original loan amount plus the interest acquired on your loan or credit card.

Interest Earned vs Paid

Interest earned involves gaining interest over a period of time from a savings account or term deposit.

When you open a savings account or a term deposit, you will earn interest as a reward from the bank (for putting your money in one of their accounts).

Interest paid involves acquiring interest on your loan or credit card that you have to pay. Both loans and credit cards charge compound interest, so you want to pay them off as quick as you can!

When you use a credit card or have a home loan, you are borrowing money. This means you will be charged interest, as well as having to pay off the amount borrowed with repayments.

What is an interest rate?

An interest rate is the percentage of interest that you will pay for borrowing money or gain for saving money.

You will often incur an interest rate on things such as loans, credit cards and bank accounts such as savings or term deposits.

An increased interest rate will benefit people with savings accounts as they will gain more money, however, for people with loans and credit cards, they will incur higher repayments.

There are two main interest rates: fixed and variable.

A fixed interest rate remains the same throughout the duration of borrowing. This means your interest rate will be set (as the rate at the time of settlement), no matter how much the interest rate changes over your loan period.

However, a variable interest rate changes depending on the bank’s interest rate at the time. This can be beneficial if the interest rate lowers during your loan period.

What is the cash rate?

The cash rate is the interest rate set by the Reserve Bank of Australia (RBA). This interest rate applies to banks and the money they borrow from each other (AKA ‘overnight loans’).

On the first Tuesday of every new month, the RBA discusses the cash rate and decides whether it will stay the same or change (either go up or down). The cash rate might change to increase economic growth, encourage spending, and ensure Australia’s money is stable and flowing well.

For example, during the height of the Covid-19 lockdowns, the cash rate dropped dramatically to try and reduce people’s repayment costs during that period of uncertainty. Now that lockdowns have finished, the RBA have started raising the cash rate again.

The RBA’s cash rate can influence the interest rates that customers receive from their chosen bank. This is because the bank can pass down their own costs (for borrowing money).  

Although bank rates usually change according to the cash rate, it isn’t always the way.

For information on how interest rates affect taking out a loan, read our blog here!