What are interest rates and how do they affect you
Interest rates have gone up several times in the last couple of months in Ghana, and it looks like they will keep rising for the foreseeable future. So, this begs the question: what are interest rates, why are they rising, and how do they affect you?
What are interest rates?
The rate of return usually in relation to loans, deposits and other financial investments is usually known as the interest rate. This rate of return is usually over a specified time period. In Ghana, it is unlawful for financial institutions to quote interest rates as daily or monthly. Bank of Ghana requires that interest rates be quoted per annum.
Interest rates are generally closely related to a concept known as the time value of money. This concept basically states that an amount of GHS 100 received today is worth more than the same GHS 100 to be received at some time later in the future. It closely follows the bird in hand argument and attaches more importance to current cash balance over future cash balance, all other things being equal.
Most people can relate to the well-known phenomenon where prices of goods and services change over time. In Ghana, prices of goods have generally risen since the start of the year. This phenomenon is known as inflation. The opposite of inflation is deflation – a situation where prices of goods and services generally fall over time. Inflation weakens the purchasing power of your hard-earned cash and thus it is important to take steps to preserve the purchasing power of your cash.
One way of protecting the purchasing power of cash is via interest rates. To compensate investors for the loss of purchasing power due to inflation, banks and financial institutions usually pay some compensation to investors. This compensation comes in the form of interest rates and is meant to cushion investors. Usually, this interest rate is higher than the inflation rate. The real return on one’s investment thus is the excess of the interest rate above the inflation rate.
The financial markets provide a platform for people who have excess funds to channel these resources to other people who need the funds. Generally, those with excess funds (lenders) prefer to lend for a shorter period whilst those with deficits (borrowers) prefer to borrow for a longer period. If you have a bank account, you surely have at some point been a borrower or a lender. Generally, if you apply for a loan and you are able to adequately demonstrate your ability to repay, you benefit from lower credit risk premiums. Credit risk is the risk that you may default and thus not be able to pay back the amount you have borrowed or its interest. Based on the size of the transaction, you may be able to obtain some preferential treatment from the bank. This is called volume premium. A tenor premium relates to how much more or less you are charged on a loan depending on how long you want the cash for. Generally, tenor premiums increase as the tenor of the loan increases.
The rate charged by the bank on your loan may either be a fixed rate or a floating rate. As the names suggest, these rates may either remain unchanged or be changed regularly over the life of the loan. In a rising interest rate environment, it is always advisable to borrow at fixed rates since that will be less expensive compared to borrowing at floating rates.
In Ghana, the regulators of the financial markets include the Bank of Ghana, the Securities and Exchange Commission, the Ghana Stock Exchange, the National Insurance Commission, and the National Pensions Regulatory Authority. It is thus crucial to engage in any form business transactions only with entities that are licensed by their respective regulators. Transacting with a regulated entity such as First National Bank, for example, affords you the opportunity to seek redress should you feel unfairly treated. A loan shark on the other hand may not be subject to the scrutiny of Regulators, and thus could treat you unfavourably.
There are two concepts that one needs to consider when looking at interest rates. First is the Monetary Policy Rate (simply referred to as the policy rate), which is the benchmark rate at which banks can borrow money from the Bank of Ghana. The current policy rate is 24.50%. The policy rate influences the Ghana Reference Rate (GRR) which also serves as a reference for the interest rate that banks charge their customers on credit products such as home loans. The current GRR rate is 27.44% and is adjusted monthly. The interest rate on an investment is often referred to as the yield on that investment.
Generally, if you apply for a loan from a bank such as First National Bank, the bank will conduct an assessment of your ability to service the loan. Based on your perceived credit worthiness among other factors, the bank may decide to approve or decline your loan application. If you are successful with your loan application, the bank charges an applicable lending rate based on your risk profile, the amount involved, available liquidity and other factors. The lending rate charged by the bank includes the reference rate (GRR) and a risk premium. The GRR is positively correlated to the monetary policy rate (MPR), so that one would expect the lending rate to go up when the policy rate goes up and vice versa.
Why are interest rates rising?
At the beginning of the year 2022, the policy rate was at 14.5% whilst the 91-day Treasury bill rate was at 12.5%. Currently, the policy rate is at 24.5% whilst the 91-day rate is at 30.96%. Yields on the 182-day and 364-day T-bills have also risen from 13.2% and 16.6% as at end of 2021 to 31.9% and 31.5% respectively.
The Monetary Policy Committee (MPC) of the Bank of Ghana meets about six times a year and uses interest rates to manage inflation. Inflation is simply how much a weighted basket of goods and services, such as groceries and petrol, goes up from one period to another, usually a year. The changes are expressed in percentages, and since the Bank of Ghana’s inflation target is between 6% and 10%, the Central Bank seeks to ensure price stability by keeping inflation in this target rate.
According to data from the Ghana Statistical Service, Ghana’s consumer inflation rate is currently at 37.2%. The high inflation is due to several issues, mainly supply chain disruptions as a result of the Russian-Ukraine war which drove prices of crude oil and agriculture commodities upwards, the depreciation of the Cedi against major trading currencies, and upward adjustments in the prices of utilities. This means that it now costs more to transport goods and produce necessities such as food. Inflation thus reduces the purchasing power of your money.
Global developments – both economic and political – have also caused consumer inflation to go up, resulting in efforts by the various Central Banks to contain the rising prices via increases in the policy rates. The Bank of England, the US Federal Reserve, as well as the South African Reserve Bank have all hiked rates on the back of inflationary concerns.
As a consumer, what does this mean for you?
If you have floating rate credit facility, whether it’s secured or unsecured, and the interest rate goes up, your monthly repayment will go up as well. You will pay more for every new loan you apply for when interest rates rise. For example, a GHS 100,000 loan will cost about GHS 2,500 more per annum now that the reference interest rate has gone up by 2.5%. This will unfortunately limit your spending as goods costs more.
Below are some quick tips to manage the strain of rising interest rates on your pocket:
- Keep track of what you spend. See where your money goes and if there are ways to cut back on some of the spending you don’t have to do. For instance, you could spend less on take-aways and treats and put that money toward your mortgage repayment or other credit.
- Move your credit debit order as close as possible to the date you get your income. This way you’ll know that your debit order has been paid and won’t have to worry about keeping money aside for the rest of the month.
- Food prices have gone up in the last few months, so look for ways to save money on food, like buying non-perishables once a month and creating a weekly menu from the pantry, then only buying a few fresh things every week.
The good thing about the interest rate cycle is that if you have savings, such as emergency savings or you live off the interest from cash investments, the interest on these savings should also go up. This means that more interest will be earned, so more interest will be paid every month.
If you do free up cash via the tips above or alternatively the increase on interest paid on cash investments, think about using that to pay off any expensive credit that you may have, saving for an emergency or putting towards your longer-term goals such as retirement savings. Save and invest with First National Bank, with as little as GHS100 and earn cool interest.
