Saving and borrowing
In society, there are people who have spare money (surplus funds) that they usually save with a financial institution. When they allow their savings to be used by a financial institution, they expect something in return. The interest rate on money deposited is the price financial institutions must pay for the use of this money. Alternatively, there are people with not enough money (deficit funds) who need to borrow from financial institutions. They, too, must pay a price for the use of this money. The interest rate on loans (borrowings) represents the price. Financial institutions make a profit by charging a higher rate to borrowers than they pay to depositors.
Short-term and long-term interest rates
Interest rates can be classified as either short term or long term. For example, you can take out a home loan with the interest rate fixed for 20 years. This is considered a long-term interest rate. You make the same payments over these years, regardless of whether interest rates rise or fall. Alternatively, when you use your credit card or take out a personal loan, you are borrowing money at an interest rate that can change in the short term. As a general rule, short-term interest rates tend to be higher than long-term interest rates.
The interest rate received by savers also varies according to how long the money is deposited for. As a general rule, long-term interest rates tend to be higher than short-term interest rates.
The interest rate received by savers also varies according to how long the money is deposited for. As a general rule, long-term interest rates tend to be higher than short-term interest rates.
Fixed and variable interest rates
Once you have decided how much you want to borrow, you can select one of two main rates of interest for your loan.
- Fixed interest rate — the interest rate is set (fixed) for the entire term of the loan. The main advantages are:
- protection from unexpected interest rate increases
- predictable payments, which make it easier to budget.
- you cannot take advantage of a fall in interest rates
- an early payout penalty if you want to clear the loan before the fixed term has expired.
- Variable interest rate — the interest rate moves up or down over the term of the loan. The main advantages are:
- if interest rates fall, your repayments reduce
- you can shorten the term of your loan if you maintain the higher repayment
- additional repayments can be made without penalty.
- if interest rates increase, your repayments will rise
- you may be forced to increase your repayments if the loan cannot be paid back within the agreed term.
- Combination loan — the interest is fixed for an initial period, usually up to 10 years, then reverts to a variable rate.
- Split loan — where part of your loan is fixed and the remaining portion is variable. For example, imagine you borrow $150 000. You may decide to fix $100 000 over seven years and leave the remaining $50 000 at a variable rate.
Interest rate worksheet
Complete the following activities to show your understanding. A hard copy is also available.
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How does the RBA set interest rates?
Setting interest rates is called Monetary Policy. Click on the link below to read the explainer tabout how the RBA sets interest rates in the Australian economy. This SNAPSHOT also has some important economic information.
What do you think interest rates are going to do in the next year?
What do you think interest rates are going to do in the next year?