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Interest rate is very important to financial decisions and it is always important for you to understand the applicable rate in all your investment decisions before committing.
Interest rate is very important to financial decisions and it is always important for you to understand the applicable rate in all your investment decisions before committing.

Why interest rate matters

Always find the best option before deciding says Bernard Otabil

This week we are going to look at one important aspect of investment, which is more to do with the expected end of our investment decisions - profit or returns! You know how important it is, right? Great!

With the exception of a few, many institutions are set up to accrue “benefits” in the form of a quantifiable return on investment. They want profit, they want a payoff.

Even social enterprises at some point would use a financial model that looks at the true value for money in the work that they do in their assessment of performance. 

They may be an NGO or some form of a truly communal venture but beyond the assessment of the number of people whose lives have been affected by what they do, is the financial assessment of whether the money could have generated something far more beneficial if it had been spent on something else.

So, you see, the real cost alone does not determine whether your money was well spent or that your investment was well laid, opportunity cost - the next best alternative that had to be given up in order for you to enjoy what you have now - also has a part to play.

Even though profit maximization is a goal that drives shareholder value and therefore investor decisions, investors may have other considerations too. Individuals as shareholders enjoy returns in the form of dividend paid by the company for using their cash to run the business’s operations and also enjoy capital appreciation, which is when the shares they own appreciate in value because of good performance or generally its public goodwill. 

The opposite is that when the company performs poorly and its share price falls on the stock market, you lose money there.

Let now provoke you with this: What then happens when you are not a stock market savvy person but someone that would want to make the most of the available cash by investing in small savings account here and there, or even buying Government bonds?

This is where, l believe, today’s investment lesson will come handy. So, let us now veer off into another area of expected returns, which is interest payment on deposits! Yes, the watchword here is interest. 

Interest payment on deposit, that is, what you accrue from the small money that you save with your bank also has the potential of contributing to your financial health.

For this reason, it is important that you take the necessary steps to ensure that you are indeed saving with the right financial institution.

To explain further, l will take a step back and look at the importance of your deposit to the bank. Deposit mobilization, which is the process by which banks would seek to convince a prospect to save with them, is an important activity in banking. 

Its importance stems from the fact that when a bank is able to secure cash from the general public other than raising such funds from another financial institution, it is able to make more money because deposits (mobilized funds from savings by individuals and corporate bodies) are cheaper.

Deposits are cheap source of funding to the bank because the interest paid on it is low- from the bank side. This is the practical explanation to this.

 Last week, the Bank of Ghana issued a public notice on the annual percentage rate interest paid by financial institutions on loans and other credit advances, as well as the average deposit interest. This listed the rates for all the universal banks for different segments of the economy that is, commerce, manufacturing, construction, etc. This was for the month of May, 2016.

The data showed that whereas average deposit interest (depending on the financial institution) was 12.3 per cent (this was the highest in this case), you could pay as much as 45.8 per cent to access credit from some of them.

Now, this is where it gets interesting for the bank. When it is able to, say, secure deposit at a cost of 10 per cent and is able to on-lend the same funds at 35 per cent, it means that it has been able to make a spread of 25 per cent. When other operational cost is an additional 10 per cent, the total margin, in terms of the real interest income reported by the bank would be 15 per cent.

Now picture the situation whereby the bank was unable to raise the required money from depositors and rather had to use the services of another commercial bank or a finance house at the rate of 26 per cent (the monetary policy rate). Even before other costs are factored in, the cost of funds is high.

Using the previous example, assuming the total operational cost is 10 per cent, and the bank still wants to maintain its interest  income at 15 per cent margin, it means that the cost of these funds would be upwards 51 per cent. This is highly significant.

Well, l hope that you have fully followed today’s class 101 on some rudiments in finance carefully.  Interest rate is very important to financial decisions and it is always important for you to understand the applicable rate in all your investment decisions before committing.

Like the interest payment on loans, the other interest that you are also exposed to is the one you have to pay when you take a credit facility from the bank-loan interest. 

There is the annual percentage rate, as mentioned above, which is very different from the quoted interest that banks normally make public. You will have to, sometimes, read the real interest that you will have to pay in the small prints.

The annual percentage rate, therefore, is the total costs of a facility to you, which will take into account loan arrangement fee (where it exists), administration costs, insurance cost, etc. When all the costs are added together with the plain rate stated, you will then get to the real cost of the facility to you. 

Failing to look at the total cost of a facility is therefore a recipe for disaster. When investing also, look around for the best rate at all times. 

On the Bank of Ghana website you will find information on all the universal banks, as far as their various interest (loans and deposits) are concerned.

 

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