Quick Explainer: Interest Rates and How They Affect You

The Reserve Bank has dropped the repo rate to 7.5%. Consequently the prime lending rate has dropped to 11%.

On Thursday the Monetary Policy Committee (MPC) of the Reserve Bank announced that the key interest rate it sets, the repo rate, would drop from 7.75% to 7.5%. What does this mean and why does it matter?

What is the repo rate?

The repo (repurchase) rate is the interest rate that the Reserve Bank charges for money (cash) that it lends to the banks.

Why is it important?

A change in the repo rate is generally followed immediately by a change in other interest rates. For instance, when the repo rate is decreased, the banks announce a fall in their “prime” overdraft rates – the rates at which they lend to their best customers. This filters through to other interest rates including home loans, hire purchase agreements, and so on. The prime rate after the MPC announcement is 11%.

What is the MPC?

The MPC is chaired by the Governor of the Reserve Bank and includes the deputy governors and officials appointed by the governor. It meets six times a year to decide on interest rates.

Why does the MPC raise or lower the repo rate?

The Reserve Bank is tasked, in terms of the Constitution, with protecting the value of the rand. Inflation erodes the value of the rand – as prices rise, you can buy less with your rand – so protecting the value of the rand means keeping inflation down.

Since about the year 2000, the National Treasury has set a target range for inflation. At the moment the target range is 3% to 6%, and the latest annual inflation rate is 3%.

Interest rates are a tool used by the MPC to keep inflation within this target range.

If inflation is high, the Reserve Bank intervenes by raising interest rates, with the objective of reducing spending power in the economy and lowering inflation. If the bank thinks the inflation risk is low, it lowers interest rates.

(See our explainer on inflation.)

What effect does this have on the economy?

A rise in the repo rate – and in other interest rates – means households and businesses have to spend more on debt repayments. This slows down demand for goods and services and lets the economy “cool off”.

A cut in the repo rate has the reverse effect, encouraging households and businesses to spend more. This can boost the economy, and many people think that in times of slow economic growth and high unemployment, the Reserve Bank should be less strict on inflation. The counter argument is that inflation hurts poor people the hardest, because they have fewer ways to deal with rising prices.

And on households?

Interest rates on borrowing and savings both change in response to changes in the repo rate. As a rule, people who have debt will benefit from lower interest rates, while people who have savings will lose. When interest rates fall, people with home loans will make lower repayments (unless they opted for a contract with a fixed interest rate) as will those who are buying cars, furniture or other goods on credit.

The changes to the repo rate and other interest rates are usually very small – often less than one percentage point – but over time they make a big difference.

For instance, on a 20-year home loan of R500,000, repayments fall from R5,332 a month, with an interest rate of 11.5%, to R5,160 a month with an interest rate of 11%. Over 20 years, this difference is considerable.

Why is it called the repo (repurchase) rate?

It is called a “repurchase” rate because it is the interest that is deducted (“discounted”) when the banks buy back (repurchase) financial assets that they provide to the Reserve Bank in exchange for cash. The repo rate reflects the interest they had to pay to have the cash.

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