What is a good interest rate?

Interest is a fee paid or received for the privilege of using someone else’s money. When you lend someone money, you receive interest. When you borrow money from someone else, you pay interest.

When you receive interest on money in your bank account, it’s because the bank lends that money on to borrowers, who pay interest. The bank takes a cut, and you get a cut too. That’s why you typically earn more interest on notice accounts, because it gives the bank assurance that they can lend that money on to borrowers for a set period.

A ‘good’ interest rate will look different depending on whether you’re a borrower or an investor or saver. Borrowers want to find the lowest possible rates to minimise the total value of any repayments. Meanwhile, investors and savers are seeking out the highest possible interest rates, to maximise their earnings. This is particularly important when you’re at the beginning of your financial journey, as you can benefit from compound interest by reinvesting any dividends or returns back into your portfolio. Compound interest can quickly add up over time, and the higher the interest rates, the more you will earn.

Interest rates for borrowers

When you borrow money from the bank, you will usually have to pay an interest fee on the loan until the capital has been paid off.

Mortgage rates are among the lowest borrower rates on the market, due to the sheer size and the track record of the mortgage market. However, if the bank considers you to be a higher-risk borrower, they may choose to charge you a higher interest fee to reflect the higher risk that they are accepting by lending you money.

Not all interest is created equal. When you borrow money that you have to pay back over a shorter period, you tend to pay a higher interest rate. Conversely, longer-term debt like home loans, student loans and business loans have lower interest rates to compensate for the fact that you’re paying back the loan over a longer period.

In order to ensure that you’re eligible for the best possible borrower rates, you should aim to have a good credit score, and you should be in a position to offer some form of collateral, for instance an asset or a deposit.

Interest rates for investors

Borrowers look for the lowest possible interest rates, but investors move in the opposite direction. The higher the interest rate, the more money you’re going to be able to make on your investment. But in the world of investing, high returns often come with higher risk. It’s very possible to earn returns of 20% or higher, but this requires a lot of due diligence and a little bit of luck. It’s just as possible to target returns of 20% per annum, only to end the year on a loss.

Banks offer some of the most consistent returns on the market, but their interest rates are also among the lowest available. However, bank savings also come with a high degree of security, as laws and regulations are in place to protect consumer funds in the even that the bank falls into bankruptcy.

Some people are happy to trade the security of bank savings for the low rates on offer. However, if you want to be in with a chance of earning a higher interest rate, you will usually have to accept a higher level of risk.

And then there are bonds. These are fixed-income assets which offer a set return, which is usually a little higher than the returns offered by bank savings accounts. They are issued by governments and corporations, with a set term time which can be as little as three months and as much as 30 years. The bond issuer offers a pre-agreed monthly, quarterly or yearly interest rate in exchange for your money. At the end of the term time, your money is returned.

Bonds are seen as lower-risk investments, but they are still higher-risk than bank savings, as there is always a chance that the bond issuer could default on a payment, or that the company or government could fail. For this reason, it’s important to research any potential bond holdings to get a sense of their quality. Ratings agencies such as Moody’s and Fitch provide ratings for most bonds, with higher-risk bonds given the lowest scores, and the bonds with the lowest risk of default receiving ratings of A, A+ or even A++.

Risk and returns

One of the core rules of investing is that the higher the returns, the higher the risk. When you invest in stocks and shares, bonds, funds, assets, commodities and alternatives, there is always a risk that you could lose some of your money. However, if you take a research-led approach to your investments and maintain a diversified, risk-balanced portfolio, you could earn annual returns far beyond what bank savings accounts can offer. This is why it’s so important to understand your own personal risk profile before making any investment.

Your risk profile will also dictate the sort of returns that you can earn. A high-risk investor will likely be hoping for annual returns of 10% or more. A medium-risk investor may be happy with 4-6% per annum, while a very conservative investor with a low risk profile will accept returns as low as 1-2% per annum.

Diversification can help to offset any potential losses in the higher-risk segments of your portfolio. For this reason, most investors will maintain a certain amount of money in low-rate cash savings, with the remaining money spread across a range of equities, bonds and other investment options.

No matter your risk profile, every investor ultimately wants the same thing - to get the best possible return on their investment, with the lowest possible risk. But there are no guarantees in finance. Do your due diligence on any potential new investment so that you can make an informed decision on the amount of risk that you’re prepared to take on, in the hunt for a good return.