Dec Jan Feb Mar April 2014

Imagine receiving an email from your bank or financial institution informing you that because of a significant change in your credit score, they’re raising the interest rate on your credit card to 23 per cent!

 

Another scenario, you’re watching the Business News and they’re talking about a recent announcement from Central Bank of Kenya (CBK) in which it is hinted that they would be raising interest rates by a quarter-point in the next week. The stock market hits a nose dive in one day!

You want to save money to buy a truck, so you invest in a five-year plan at the local bank with an interest rate of five per cent. But when the period matures, you notice that the price of the truck has gone up by three per cent. You really only made two per cent interest. What’s going on here?

Before you get all confused, it is important to know that interest rates aren’t wicked. They’re the price of living in a world that relies heavily on credit and debt. If interest rates never existed, lenders would have no reason to let you borrow money. And if you couldn’t borrow money, you could never pay for that piece of land, buy a house or a car, or enjoy many other advantages of having credit.

To set the ball rolling, let’s start with a basic introduction to interest rates. According to Investopedia.com, an interest rate is the cost of borrowing money. A borrower pays interest for the ability to spend money now, rather than wait until he’s saved the same amount. Interest rates aren’t just random punishments for borrowing money. The interest a lender receives is his compensation for taking a risk.

With every loan, there’s a risk the borrower won’t be able to pay it back. The higher the risk that the borrower will default (fail to repay the loan) is, the higher the interest rate. That’s why maintaining a good credit score will help lower the interest rates offered to you by lenders. The nice thing is that interest rates work both ways. Banks, governments and other large financial institutions need cash too, and they’re willing to pay for it. If you put money into a savings account at a bank, the bank will pay you interest for the temporary use of that money.

Governments sell bonds and other securities for the same reason. In this case, you’re the lender, and the interest rate is your compensation for temporarily giving up the ability to spend your cash. Unfortunately, savings accounts and government-issued bonds pay relatively low interest rates because the risk of defaulting is close to zero.

With this basic understanding of how interest rates operate, let us look at some areas we would need to put more emphasis on during the course of our businesses.

Prioritize your debts

If you are in a diverse range of loans, the first thing to do is to rank them according to interest rates and decide which ones should be repaid first. An equally important debt management strategy is to keep away from new discretionary loans for short-term borrowing needs. This is especially important when interest rates are high because the cost of repaying the loan will be higher too.

Liquidate low return on investments

This is an important factor that you may need to consider if you are holding on to low-yielding investments at the point you have to repay high-interest loans. You should compare the interest rate you are earning on a given investment and that being charged on your debts, and then think of liquidating some of your low return investments to pay your dues.

Do some window-shopping

If you are looking for a new loan when interest rates are high, you need to take time to shop around even more. Banks offer the best deals when they do not get enough borrowers because of high rates. The deals can range from ‘limited period’ special rates or schemes, to corporate discounts.

Negotiate

If you have a good credit history or a previous relationship with the same bank, even the bank may not necessarily expect you to agree to the rate that is offered first. You always have the option of negotiating for the rates. As a smart borrower, you should be looking at your loan every few years to see if you are still getting the best deal. Even when you are repaying a loan, banks usually allow you to shift to a lower rate of interest being offered to new borrowers (home loans) for a small fee, or even without it, or eventually migrating to another bank when the deal is better.

Interest rates aren’t what they used to be. Rates a year or even a month ago are different from those prevailing today in our financial markets. That’s because interest rates flex with the ebb and flow of general economic activity. Interest rates also change in response to the expectations borrowers and lenders have about the future level of prices.

Changes in the shilling’s value on foreign exchange markets or in interest rates and, of course, the closely watched policy actions taken by the CBK all have a pronounced impact on the level of Kenya’s interest rates. There are, indeed, a host of factors that feed into determining the general level of interest rates. Interest rates play an important role in our market economy. As signals direct the flow of a city’s traffic through a complicated grid of intersecting streets and avenues, interest rates channel the flow of funds from savers to borrowers. Usually, the funds flow through financial intermediaries such as banks, mutual funds and insurance companies.

A balance is struck between the demand for funds by borrowers and the supply of funds from savers by an ever-adjusting level of interest rates. Changes in the quantity of funds available to finance the spending plans of borrowers as well as changes in borrowers’ demands for funds alter interest rates which, in turn, affect the levels of consumer and business spending, income, the gross national product, the employment of resources and the level of prices.

The economy is a living, breathing, deeply interconnected system. When the Fed changes the interest rates at which banks borrow money, those changes get passed on to the rest of the economy. Familiarizing yourself with what makes the CBK tick will give you a leg up when it comes to predicting their next moves, as well as the future direction of a given currency pair.

The writer is the Chief Executive Officer of Gateway Success Consultancy Ltd.

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