Your guide to Interest Rates
No matter what kind of loan you are considering, the interest rate is undoubtedly one of the most important terms to understand. Many people know that the interest rate determines the cost of the loan, but not everyone is familiar with the detailed differences between various types of interest rates. For example, it is useful to know the difference between the nominal interest rate, the annual percentage rate (APR), and the reference interest rate to make the best choice when comparing loan offers.
Like many seemingly simple loan terms, the concept of interest rate is actually much more complex than it might appear on the surface. In this article, we will cover everything you need to know about interest rates on loans and guide you on how to find the best rate for your loan, regardless of the type.
What Does Interest Rate Mean?
Technically, the interest rate is the price of money. It is the cost paid as compensation to the owner of the money for the period during which another individual or entity uses that money for their own purposes. Typically, interest is paid to banks or other financial institutions, but banks themselves may also pay interest to their customers. In that case, the bank is effectively the borrower.
When you take out a loan, the interest rate expresses the percentage of the loan amount you must pay annually as a fee for borrowing the money. Although interest could be calculated for shorter periods, most loans quote the interest as an annual rate. For example, short-term reference rates, such as the New Zealand Bank Bill Swap Rate (BBSW), are available with shorter intervals, sometimes monthly.
How Is the Annual Interest Rate Calculated in Money?
The annual interest is calculated using a simple interest formula. This formula shows the yearly interest on the loan, but it can also be used to calculate the total interest over the full loan period by multiplying the annual interest by the number of years.
The formula is: (P x R x T) / 100.
- P = principal loan amount
- R = annual interest rate in percentage
- T = loan term in years
Note that this formula calculates the nominal annual interest rate, not the effective annual rate. It does not take into account other loan costs such as fees and commissions. You can use online loan calculators to get a more accurate picture of the total cost of different loans, including all fees.
Fixed Interest Rate and Variable Interest Rate
The first step in examining the interest rate of a loan is to determine whether it is a fixed or variable rate. A fixed interest rate remains constant throughout the entire loan term at the rate agreed upon when the loan contract was signed. On the other hand, a variable interest rate can change over time, typically reviewed once a year or at another specified interval.
Fixed Interest Rate
Fixed interest rates are usually used for shorter-term loans, such as payday loans or quick business loans. The advantage of a fixed rate is the certainty it provides—you know exactly how much the loan will cost over its lifetime. The downside is that fixed rates usually start higher than variable rates.
Financial institutions offer fixed rates based on current market conditions and their own assessment of how interest rates will move during the loan period. Because of this, a fixed rate is generally higher than the current official benchmark interest rate.
Variable Interest Rate
Variable interest rates are commonly applied to longer-term loans, such as mortgages. Their advantage is a typically lower rate at the time the loan agreement is made. The downside is the uncertainty regarding where the interest rate will move in the future.
In New Zealand, variable interest rates often reference the official cash rate set by the Reserve Bank of New Zealand, or the BKBM (Bank Bill Benchmark Rate), which reflects short-term market interest rates. When these benchmark rates increase, the cost of monthly mortgage payments on variable-rate loans will also rise.
Different Types of Interest Rates
Besides fixed and variable rates, borrowers should also be familiar with different types of interest rates, especially nominal interest rate and the annual percentage rate (APR), which help in understanding the true cost of borrowing. Other important terms include the benchmark rate, market rate, and reference rate.
Nominal Interest Rate
The nominal interest rate is the rate you will find in your loan contract. It is the rate that banks and finance companies advertise when marketing their loans, so it serves as an initial offer to consider before you commit.
However, the cost of a loan is not determined solely by the nominal interest rate. In addition to this rate, other charges such as application fees, service fees, and administration fees are added. These extra costs can significantly affect the total expense of the loan.
The nominal rate itself consists of the benchmark interest rate plus the lender’s margin. In New Zealand, the benchmark rate is often based on the official cash rate or market rates like the BBSW, plus the lender’s own margin. Comparing these margins between lenders is essential for finding the cheapest loan offer.
Annual Percentage Rate (APR)
The APR is the figure that provides a clearer picture of the real cost of a loan. It includes the nominal interest rate plus all associated fees and charges. This comprehensive rate helps you compare different loan offers fairly.
When we help customers compare loans, we focus on the APR so that you always know the true cost after all the marketing hype. For example, a loan with a low nominal interest rate might turn out to be expensive once high administration fees are factored in, especially for smaller loan amounts.
Official Cash Rate
The official cash rate (OCR) is set by the Reserve Bank of New Zealand and serves as the benchmark for short-term interest rates in the market. This rate affects the interest rates banks offer to their customers because it forms the foundation for banks’ own market rates.
When the OCR is high, economic growth tends to slow down, and loans are granted on tighter terms. Conversely, a low OCR encourages borrowing and investment because loan money is cheaper.
Market Rate and Reference Rate
The market rate is a reference interest rate determined by the forces of supply and demand in financial markets. These rates are usually not directly visible to consumers but influence the rates applied to loans taken by governments, banks, and local authorities. The BBSW is one such market rate used in New Zealand.
Loan reference rates are often linked to market rates like the BBSW, to which lenders add their own margin. Understanding these base rates helps you grasp why your loan’s interest rate may fluctuate.
Differences Between BBSW and Bank Prime Rate
When discussing variable-rate loans, you may hear references to different benchmark rates like the BBSW and the bank’s Prime rate. What do these terms actually mean?
Simply put, BBSW is a benchmark rate calculated daily based on money market transactions among banks, serving as a common reference across financial institutions. The Prime rate, on the other hand, is a rate individually set by each bank and often reviewed only a few times a year.
For borrowers, the key difference is that loans linked to the BBSW tend to have more frequent interest rate changes, reflecting market fluctuations. Loans tied to a bank’s Prime rate are typically more stable but may be adjusted at the bank’s discretion.
Though they are separate, the Prime rate often moves in line with the BBSW but with a lag. This can be either beneficial or detrimental to borrowers depending on market conditions. Generally, the Prime rate is seen as a steadier alternative for variable-rate loans.
How to Get a Low Interest Rate on Your Loan
The best way to secure the lowest interest rate on a personal or business loan is by comparing loan offers from multiple lenders. Financial advisors and online comparison services can help you by doing the heavy lifting, evaluating total loan costs, and recommending the most affordable options based on your financial situation.
By submitting a single loan application through such a service, you can receive multiple tailored loan offers quickly via email. Many loans can be approved and funded on the same day. The entire process can be done online without any extra fees, and you only pay the interest rate agreed upon—no hidden costs or surprises.
Finding a loan with a favorable interest rate can save you a significant amount of money over time, so it’s worth taking the time to understand these terms and shop around carefully. Whether you need a short-term loan or a mortgage, knowing how interest rates work will help you make smarter borrowing decisions and keep your finances in better shape.