(Graphic: iStock/AlexLMX)
The Reserve Bank’s proposal to do away with the prime lending rate as the starting point at which consumers borrow money from commercial banks and only use the repo rate as a reference point to determine the cost of debt such as home loans, car financing and credit cards will simplify rather than complicate consumers’ lives, say experts.
If only the repurchase rate (or the repo rate at which banks borrow money from the Reserve Bank) is used as a benchmark, banks’ customers will be able to more easily compare offers from different banks. They will also be able to more easily calculate how their debt repayments change as interest rates change.
In a recent discussion document, the South African Reserve Bank (SARB) says the prime lending rate should be replaced with the SARB policy rate (SPR), commonly known as the repo rate. This will increase transparency, create a clear link between monetary policy decisions and lending rates, and make the cost of debt loans more understandable for consumers.
According to Benay Sager, chief executive of Debt Busters, this will create greater disclosure and transparency about how banks set the interest rate at which consumers borrow, and make it easier for consumers to understand.
Although the interest will be charged at a margin above the SARB policy rate, rather than the prime lending rate, this will not change the cost of debt in rand and cents.
The prime rate has historically been set at 350 basis points above the repo rate, but this was not a regulatory prescription. This was relative to the SPR and a technical adjustment by the SARB, says the document.
Methodical transition provided for millions of contracts
The Reserve Bank recommends that the transition to the exclusive use of the SPR commences in 2027, following proper consultation and data analysis. This must happen methodically and carefully, with awareness and communication as pillars of this transition to reassure consumers. This is because so many home mortgage loans, personal loans and credit agreements are linked to the prime rate.
It is estimated that there are currently more than 12 million contracts with a total value of R3.2 thousand billion that use the prime rate as a reference. The SARB says retail mortgage loans and consumer loans represent around 37% of this total.
This is how it works in practice
Stephan Potgieter, CEO of the mortgage broker BetterBond, explains that the proposal will eliminate the “middle man” to show the market and consumers exactly what lending rates banks charge.
“Although the reform will not automatically lower the cost of debt, it changes the way interest rates are passed on by making the pricing structures more direct and easier to understand. This demonstrates the country’s commitment to financial efficiency and transparency.”
According to the current system, consumers may assume they are getting a good lending rate when it is linked to prime with a minus, while forgetting that prime is already 350 basis points higher than the rate at which banks borrow from the Reserve Bank.
According to the current model, a commercial bank quotes a home mortgage applicant for example “prime plus 1%” or “prime minus 1%”. In effect this means:
- Example 1: Repo rate (currently 6.75%) + 3,5% (prima) +1% = 11,25%
- Example 2: Repo rate (currently 6.75%) + 3,5% (prima) minus 1% = 9,25%
Easier calculation
If only the SPR is used, banks will have to be clearer about how much the margin in the interest they charge is above the repo rate. With the prime rate falling away, it looks like this:
- Example 1: Repo (tans 6,75%) + 4,5% (instead of + 3.5% + 1%) = 11.25%
- Example 2: Repo (currently at 6.75%) + 2,5% (instead of + 3.5% minus 1%) = 9.25%
Potgieter says that in this way, homeowners will know exactly what their home loans cost and it will also strengthen mortgage brokers’ hands in interest rate negotiations with banks regarding mortgage loans.
Under the new system, homeowners will not have to make an additional calculation if there are changes in the repo rate (the SPR). If the rate drops to, for example, 6.25%, this is immediately the new base rate:
- Example 1: 6.25% (a reduced repo rate) + 4,5% = 10,75%
- Example 2: 6.25% (a reduced repo rate) + 2,5% = 8,75%
Little actually changes
(Archive photo: Maroela Media)
Sager says that in practice this does not mean banks will suddenly collect more interest debt or consumers will suddenly pay more interest. Banks will still grant loans based on the risk profile of the borrower – thus, the customer’s ability to repay the debt.
If the SARB’s proposal materializes, existing home mortgage and other credit agreements will be adjusted to reflect the new formula and calculation, but this will not change the effective interest. The answer is the same, but the way you arrive at that answer is simpler, he explains.
The Banking Association of South Africa (Basa) said earlier this year that any change in the prime rate will not change the cost of loans in rand and cents to banks’ customers, because the interest rate that banks’ customers have to pay depends on several factors.
This includes:
- That which costs the banks money. Banks not only charge interest, but also pay interest to their depositors or other institutions from whom they borrow money. Furthermore, banks obtain equity capital from shareholders to whom dividends are payable.
- The borrower’s (individual or company) credit profile is a determining factor. Banks determine whether the borrower’s income is sufficient to repay the loan according to the terms of the agreement.
- The bank’s risk appetite: Individual banks’ risk appetite varies according to their business model and their liquidity and interest rate risks.
Basa says that in a 2010 study on the same subject, the Reserve Bank found that the gap (spread) between the repo and the prime rate is irrelevant in determining lending rates.
Repo rate in other cases also only point of reference
Sager says the Department of Trade, Industry and Competition’s (DTIC) rules on the maximum interest rate that credit providers may charge are also based on the repo rate as set by the Reserve Bank. It does not use prima as a reference.
This DTIC calculation formula for the maximum annual interest rate permissible per credit product usually uses a fixed percentage which is added to the current repo rate.
He says that the reference to and use of one definition, namely the SARB policy rate, will simplify the lending landscape in South Africa. Apart from doing away with different criteria on how the cost of debt is determined, the use of different definitions that need to be explained to consumers also brings additional costs to the lending environment.
Healthy credit profile remains best bargaining tool
Sager emphasizes how important a healthy credit profile and score is for people who want to take on debt. The more responsible you are with your credit, the higher your credit score, and the more comfortable institutions will feel that you will be able to repay the loan amount.
“Good financial management on a personal level remains very important and helps people who want to borrow money.”
