Handle Interest Rates with Knowledge
By James Abola
It seems there is a conspiracy among many professions to lock other people out of their fields through the use of jargons and abbreviations. I once attended a meeting in the education sector where everybody was talking in abbreviations which made no sense to me as an outsider. Since I had been brought in as a consultant, I had to swallow my pride and request them to use proper words and not acronyms.
The field of finance is not any better either with things like Repos, buy, sell, options having meanings that by pass non financial mortals. The trend in most economies now is for individuals to take personal charge of their investments including retirement planning. This makes it more vital to know what is meant when the ‘financial types’ get talking and selling to you products.
I have come to learn over time that interest rate can mean many things and should not be taken at face value. When looking at interest rate many aspects need to be taken into account: what time period is it quoted for and how is it calculated. While most formal institutions quote annual interest rates, the less formal ones like the money lenders quote rates for shorter periods, usually per month. A money lender recently told me he charges interest of 30% per month. The manner of calculation is also of great importance, most people assume simple interest calculation. So in the case of the money lender alluded to here, you only pay interest of 30% on the original (principal) amount borrowed. At times however the calculation is for compound interest. So in the case of the man lending at 30% per month if he lent out Shs 1m in the first month he will demand total repayment (principal and interest) of Shs 1.3m. If no repayment is made at all by the third month the total required will be Shs 2,197,000.
It certainly pays to know what period and the manner of calculation used whenever interest rates are mentioned. Otherwise you might be digging a hole from which you can not escape. Both theory and experience have shown that people who start saving and investing early in life can ride on the power of compound interest to become wealthy or financially secure. Basically what is done here is to plough back whatever earning is made on the investment so that the principal keeps growing.
Interest rates can also be real or nominal. The nominal rate is what is usually quoted i.e. it is the rate expressed in money terms, while the real rate is the nominal rate adjusted for inflation. The approximation used is that the real rate equals nominal rate minus rate of inflation. So if a bank is paying depositors interest rate of 6% per year and the annual rate of inflation is 7.2% then the real rate got by depositors is -1.2%. The rate of inflation measures the average rise in price levels. If price levels are rising at 7.2% but your savings is only growing at 6% then it means that you are actually loosing purchasing power by keeping the money on a deposit account. When considering the rates earned on savings or investments it is therefore important to know what the real rate is instead of only looking at the nominal rate. From the point of view of a borrower a low or even negative real rate is most welcome.
Another factor to consider when viewing interest rates is whether the interest rate is fixed or variable. A fixed rate is agreed at the beginning of the transaction while a variable or floating rate changes over the life of the transaction. Where there is room for negotiating the type of interest rate, remember there are advantages and disadvantages to both fixed and floating rates. Most times rates for loans tend to fixed while the interest rate on overdrafts tend to be floating.
When it comes to lending, banks normally advertise their prime rate. That is the rate at which they will lend to their best customers, the ones with perfect securities, good history and assured liquidity. What you need to know is that it is virtually impossible for a small borrower to get the prime rate. The small or individual borrower normally gets a rate which is some percentages higher than the prime rate.
As you can see interest rates are like double edged swords and should be handled with great knowledge.
It seems there is a conspiracy among many professions to lock other people out of their fields through the use of jargons and abbreviations. I once attended a meeting in the education sector where everybody was talking in abbreviations which made no sense to me as an outsider. Since I had been brought in as a consultant, I had to swallow my pride and request them to use proper words and not acronyms.
The field of finance is not any better either with things like Repos, buy, sell, options having meanings that by pass non financial mortals. The trend in most economies now is for individuals to take personal charge of their investments including retirement planning. This makes it more vital to know what is meant when the ‘financial types’ get talking and selling to you products.
I have come to learn over time that interest rate can mean many things and should not be taken at face value. When looking at interest rate many aspects need to be taken into account: what time period is it quoted for and how is it calculated. While most formal institutions quote annual interest rates, the less formal ones like the money lenders quote rates for shorter periods, usually per month. A money lender recently told me he charges interest of 30% per month. The manner of calculation is also of great importance, most people assume simple interest calculation. So in the case of the money lender alluded to here, you only pay interest of 30% on the original (principal) amount borrowed. At times however the calculation is for compound interest. So in the case of the man lending at 30% per month if he lent out Shs 1m in the first month he will demand total repayment (principal and interest) of Shs 1.3m. If no repayment is made at all by the third month the total required will be Shs 2,197,000.
It certainly pays to know what period and the manner of calculation used whenever interest rates are mentioned. Otherwise you might be digging a hole from which you can not escape. Both theory and experience have shown that people who start saving and investing early in life can ride on the power of compound interest to become wealthy or financially secure. Basically what is done here is to plough back whatever earning is made on the investment so that the principal keeps growing.
Interest rates can also be real or nominal. The nominal rate is what is usually quoted i.e. it is the rate expressed in money terms, while the real rate is the nominal rate adjusted for inflation. The approximation used is that the real rate equals nominal rate minus rate of inflation. So if a bank is paying depositors interest rate of 6% per year and the annual rate of inflation is 7.2% then the real rate got by depositors is -1.2%. The rate of inflation measures the average rise in price levels. If price levels are rising at 7.2% but your savings is only growing at 6% then it means that you are actually loosing purchasing power by keeping the money on a deposit account. When considering the rates earned on savings or investments it is therefore important to know what the real rate is instead of only looking at the nominal rate. From the point of view of a borrower a low or even negative real rate is most welcome.
Another factor to consider when viewing interest rates is whether the interest rate is fixed or variable. A fixed rate is agreed at the beginning of the transaction while a variable or floating rate changes over the life of the transaction. Where there is room for negotiating the type of interest rate, remember there are advantages and disadvantages to both fixed and floating rates. Most times rates for loans tend to fixed while the interest rate on overdrafts tend to be floating.
When it comes to lending, banks normally advertise their prime rate. That is the rate at which they will lend to their best customers, the ones with perfect securities, good history and assured liquidity. What you need to know is that it is virtually impossible for a small borrower to get the prime rate. The small or individual borrower normally gets a rate which is some percentages higher than the prime rate.
As you can see interest rates are like double edged swords and should be handled with great knowledge.
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