How interest rates work

Estimated reading time
 5 min

In this article

• What is an interest rate?
• How do interest rates work?
• Different types of interest
• Common interest rate terms and meanings

There’s been a lot of talk about interest rates of late. And if you’ve heard words like fixed or variable… but don’t exactly understand what they mean, then you’ve come to the right place. So what are interest rates? And how do they work?

What is an interest rate?

Put simply, interest rates are the amount of money you’re charged (or earn) for borrowing (or saving) money.

Interest is generally divided into two categories – ‘interest earned’ and ‘interest paid’.

Interest can be earned…

1. through a savings account such as the ANZ Online Saver, for example, which gives you flexibility to access your savings at any time while still earning interest on your deposits.
2. through a term deposit, which rewards you with a known rate of interest for a set term (say, 12 months).

Interest can be paid…

when you borrow money, including using a credit card or when you take out a home loan, student, car, personal or business loan.

How do interest rates work?

Interest rates in Australia are generally based on the Reserve Bank of Australia (RBA)’s official cash rate. Each night, banks lend and borrow money from each other in a market known as the ‘cash market’. The cash rate is the interest rate earned or paid on these loans – a target set by the RBA. But while the RBA determines the cash rate target, each bank sets their own interest rate. Meaning? The amount of interest you pay on your loan or earn on your savings will vary between providers, so it pays to do your research.

You can find out what ANZ’s current home loan interest rate is by looking at the home loan rates and offers page.

Different types of interest

There are two ways interest can be applied to your bank account:

1. Simple interest is paid at an agreed frequency, and you only earn interest on your initial savings deposit, meaning interest isn’t added to the closing balance of the account.

2. Compound interest accounts, on the other hand, have a snowball effect on your saving. This is because you’re earning interest on both your initial deposit AND any interest you’ve accrued since opening your account – so you’re essentially earning interest on your interest. See if compound interest can boost your savings!

   When it comes to paying compound interest, however, interest accrues each month based on the total value of your loan, including interest you’ve already paid. Home loans mostly use compound interest, which is why it’s often a smart idea to pay down the balance as quickly as you can.

Common interest rate terms and meanings:

Fixed rate

Fixed interest rates are a single rate, set at the start of your loan. They remain consistent over either the entire period of your loan, or a set period of time (usually between one and five years). The advantage of a fixed rate is that you aren’t subject to fluctuations in interest rates set by the RBA and you know in advance exactly what your loan repayments will be each month.

It's important to note though, that if the interest rate drops, you’ll continue paying the fixed rate previously agreed upon.

Variable rate

Variable home loan rates can change depending on interest rate changes. Sometimes you’ll benefit when rates drop and sometimes your rate could go up. Variable rates are often higher than fixed rates, but they also often come with home loans with other benefits like offset accounts and wealth packages. You could also consider splitting your loan between fixed and variable to get the best of both.

Tiered rate

With a tiered rate, you earn different rates of interest depending on the balance of your account. Tiered rate accounts provide a great incentive to reach a set savings goal, because once your account balance exceeds a certain amount, they pay a higher rate of interest on the whole balance. ANZ Premium Cash Management Account is an example account where the interest rate is tiered.

Banded rate

With banded interest rates, different rates of interest apply to different parts of your account balance. For example, the interest paid on the first $9,999 of your balance may be different from the interest paid on the part of your balance between $10,000 and $20,000.

Comparison rate

When comparing the rates on different loans, it pays to look at the comparison rate – which is what the loan is really going to cost you. Instead of just comparing interest rates, the comparison rate also takes into account fees charged by the bank (annual fees, for example), producing a percentage value that allows you to compare the monthly repayments on your loan with far greater accuracy.

Do you find interest rates fascinating now? Perhaps not, but understanding what interest rates are, and how interest rates work, can reap some financial dividends right now and into the future.

Now you’ve got interest down pat – want to learn about inflation?