My Money

Olebile Makhupe | Monday August 23, 2010 00:00

The level of interest rates can be used to determine how profitable your investments are or how much you pay for money that you borrow. The cost of goods often factors into account the level of interest rates which often affects the cost of production...the areas in which interest rates affect us are limitless.

Interest Rates and the Cost of BorrowingCentral banks (an example would be Bank of Botswana) use official interest rate instruments to achieve different outcomes in the economy. In Botswana, the key official rate is the bank rate, which is set by Bank of Botswana, which is then used by commercial banks in determining rates at which they can lend to the their customers. This rate is reviewed on a frequent basis and may be increased or decreased depending on what the Central Bank wants to influence.

Commercial banks then set what is called the 'prime rate', which is a reference rate which is related to the bank rate, and often moves in tandem with the bank rate. At the moment, the prime rate for commercial banks is set at 1.5 percent above the bank rate, so as an example, if the bank rate is 10 percent, then the prime rate will be set at 10 percent plus 1.5 percent= 11.5 percent. If you've ever applied for a loan, you may have heard your bank refer to the cost of the loan at Prime rate plus a certain margin on top, or minus some margin. If the rate you are being charged is Prime plus 3 percent, and assuming the prime rate is 11.5 percent, then it means the cost of the loan will be 14.5 percent.

It is important that whenever you borrow, you ask about the margin over or under the prime rate, as this is often a reflection of the cost of the money that the bank is lending to you, and also reflects the risk that the money lent may not be returned (in other words, cost of possible default, or what is often called credit risk). If this margin is high then it shows the loan is considered to be of a higher risk, while a lower margin often reflects more favourable credit worthiness of the borrower. If you are a good customer with a stable income, and proven history of being able to pay back your debt, you are then often in a position to negotiate this rate and ensure your pricing is lower.

What else do you need to know as a borrower?The cost of borrowing varies from one financial institution to another, therefore before you borrow you need to do your homework by comparing borrowing costs. This will ensure you access borrowing at the most competitive cost and reduce your debt servicing burden.

In addition, different borrowing instruments are priced differently, therefore having access t information on the different types of debt instruments will ensure you go for one that is most appropriate to you.

Floating Rate versus FixedYou may sometimes be given the choice between a floating or a fixed rate loan. A floating rate loan essentially means the cost of the loan may change over time whenever the pricing instrument changes.

As an example, using the information shared above, if you have a No Mathata loan which charges you Prime rate plus 5 percent, and assuming the prime rate is currently at 11.50 percent, then the cost of the loan will be calculated at 16.50 percent. If however there is a 0.5 percent reduction in the bank rate which leads to a reduction in the prime rate of the same percentage, in our example, from 11.5 percent to 11.00 percent, then the cost of your loan will be recalculated to 16.00 percent (prime rate of 11.00 percent plus 5 percent margin). The same thing will happen if the rates go up- the cost of borrowing will also go higher. It is therefore very important to understand that your cost of borrowing will not remain the same when you are borrowing on a floating rate basis, and this will result in either an upward or a down ward revision to your installment.

A fixed rate loan is one where the cost of borrowing remains the same during the entire period of the loan. Under fixed rate loan arrangements, if say you have a mortgage which costs you a fixed rate of 10% payable over 10 years, then for the entire period of ten years the rate will remain the same and the installment will also not change.

The bank rate may go up or down, but this will not affect you. The downside risk in borrowing on a fixed rate basis is that if rates come down by a significant proportion like they did in the past two years, then you are excluded from benefiting from this reduced borrowing cost. If rates continue to go up though, you may then benefit from a lower cost of borrowing.

Olebile Makhupe is the Head of Global Markets at Standard Chartered Bank Botswana. For feedback and contributions please email-mymoney@mmegi.bw