Interest Rates and Your Financial Wellbeing
Every time we want to borrow, regardless of whether it is to buy a car, house, personal loan, credit card, or any other facility in the form of a loan, the first thing we should know is how much is the interest rate charged.
It is essential as the interest rate determines the amount of the entire loan you took based on the chosen loan period. The interest rate and loan term will determine the monthly installments you must pay.
For example, you want to buy a car worth RM100,000. Before making any decision, you should find out the monthly installments you need to pay and the total amount of loan you need to bear.
Let's say you pay 10% of the car price in advance, incur an interest rate of 3%, and borrow for 9 years. The total monthly installments to be paid is RM1,058.33, and the total loan amount is RM114,300 (Use the Car Loan Calculator to do the calculations.
However, if you are charged an interest rate of 5%, the amount of monthly installments to be paid increases to RM1,208 while the total amount of the loan increases to RM130,500.
A 2% difference in interest rate causes your loan amount to increase by RM16,200 while the monthly installment increases by RM150 every month.
The higher the interest rate, the higher the overall cost of the loan that needs to be borne; therefore, as a consumer, you need to be wise in making comparisons to get the best loan to optimize the value of your money.
Suppose the difference of RM150 in the monthly installment is invested in an investment that gives an average annual return of 5% per year for 9 years. In that case, you can accumulate savings of RM13,587 if the capital and dividends are not withdrawn during the investment period.
The Effect of Interest Rates on Loans and Investments
For Loans
Lenders such as banks will charge interest on the loan granted. This interest rate is actually the cost of borrowing, where a high interest rate will make the loan more expensive while a low interest rate makes the loan more affordable.
There are two types of interest rates charged, namely:
- Fixed interest: The rate charged is fixed throughout the loan period
- Variable interest: The interest rate changes based on the Base Rate Overnight (OPR) set by the National Bank.
For Savings / Investment
For savers: When you keep money in a Savings Account, the bank will pay interest for allowing them to use your money. However, the interest rate given is minimal. It may not affect the money saved, especially if it is often withdrawn.
For investors: Interest rates also affect investments such as bonds and bank fixed deposits. For example, if you buy a bond, you have actually lent money to the bond issuer and in return, you will receive interest.
In investment, the interest rate is often referred to as the return or dividend investors receive from their investment. For low-risk investments, the rate of return may be around 2-3%, while for high-risk investments, it may return between 5-7%, depending on the current economic environment.
Loan vs Investment Considerations
We take a simple example to explain how you can manage your finances better by understanding the impact of interest rates on your finances.
Loan
For example, Credit Cards charge 18% interest per year and 1.5% per month. If you use a credit card and do not pay within the interest-free period, you will be charged 18% interest on the goods purchased.
Let's say you buy a designer handbag worth RM5,000 and only pay the 5% minimum rate to keep the credit card active. Outstanding debt from the purchase of this bag will be subject to compound interest. Thus, if you only pay 5% every month, you will pay a total interest of RM1,875 and need 69 months to complete it. This makes the actual price of the bag RM6,875, including interest.
When you buy goods using a loan facility with high interest rates, you pay much higher than the original price.
Therefore, when using any loan facility, you must assess the interest rate charged, as any errors in the judgment will not only lead you to bear an unnecessary financial burden but also cause your cash flow to be disrupted.
Investment
You are encouraged to invest to avoid using a loan to buy desired items. For example, you can invest RM200 monthly in a unit trust with an average return of 5% annually.
With an investment capital of RM4,800, you receive a return of RM252, compared to the interest rate of RM1,875 you have to pay if you use a credit card that charges 18% interest per year.
The difference is you managed to collect RM5,000 in 2 years, whereas you need about five years to pay off the credit card debt.
The Importance of Understanding Interest Rates
Understanding interest rates is essential for managing personal finances; therefore, deciding to take out a loan should be done with the correct information, consideration, and guidance so you are not burdened with high loan costs.
Most importantly, when deciding to take out a loan, compare the interest rate charged and the financing period to determine the amount of monthly installments to be paid.
Sometimes, avoiding borrowing is the best option because it gives you more flexibility in financial management, and your money is not tied to monthly commitments that need to be met.
Use the calculator tools at ASNB Academy to help you calculate the difference between an investment and a loan to optimize your money.