Interest Explained for Dummies

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What is interest?

Simply put, interest is the cost of using or borrowing the money of someone else. Interest refers to two related but different concepts about the cost of money, namely:

• The cost for the right of borrowing money from a financial institution or somebody else.
• The amount an account holder or depositor earns for keeping money in an account with a bank, such as a savings or deposit account, enabling the bank to lend money to others.

 

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What is the interest rate?

Interest is calculated as a percentage of the original amount, also referred to as the principal or capital, of the loan. The interest rate is typically quoted as an annual rate, the annual rate of interest paid to investors and depositors and charged to borrowers. However, interest can also be calculated for periods that are longer or shorter than a year, such as a quarter. When a borrower is regarded to be low risk, the borrower will usually be charged a lower interest rate, and vice versa.  

Types of interest

Simple interest

Simple interest, also referred to as flat-rate interest, is when the interest cost is calculated on the principal (original amount) of a loan over a particular period of time. The principal amount does not change during the term of the loan. It is the simplest method of calculating interest and does not allow for the effect of compounding. Therefore, it is also known as non-compounding interest. The formula for calculating simple interest is: Simple interest = P x r x t, where P = principal amount, r = interest rate, and t = number of a specific period of time, such as a year or month. The period of time must reflect the same time frame as the interest rate. For instance, if the interest is indicated as a per annum (yearly) rate, then the number of periods of time must also be expressed in years. For example, if the yearly interest rate is 7% and the time period is 60 months, then the period will be indicated as 5 years in the calculation. Likewise, if the interest rate is indicated as 10% per year, but a quarterly interest rate is required, then the quarterly interest rate is 2.5% (10% divided by 4). Example of simple interest: An individual borrows R1 000 000 from a financial institution at a simple interest rate of 7% per year for a period of 5 years. This will translate into an annual interest payment of R70 000 (R1 000 000 x .07). After 5 years, the borrower would have paid R350 000 interest (R1 000 000 x .07 x 5). For the calculation of the interest, the percentage (7%) was converted into its decimal form (0.07) by dividing it by 100.

Some applications of simple interest

• Government bonds

Typically, government bonds pay simple interest in the form of coupon payments.

• Vehicle loans

Vehicle loans are amortised monthly, meaning part of the monthly installment is allocated to pay the outstanding monthly balance of the loan and the remainder covers the interest payment. As the outstanding balance declines, the monthly interest payable reduces. There is no compounding effect on the interest itself, as it is always considered as paid in full for the specific month.  

Compound interest

Benjamin Franklin, one of the Founding Fathers of the USA, described compound interest as follows: ‘Money makes money. And the money that money makes, makes money.’ Compound interest, also called interest on interest, is applied when interest is charged monthly on the principal amount as well as the accumulated interest from the previous periods. For example: An individual borrows R1 000 000 from a bank at a compound interest rate of 7% per annum for a period of 5 years. Compound interest = R402 552; simple interest = R350 000. A difference of R52 552 over the five- year period.

Some applications of compound interest

• Deposit accounts

Typically, banks pay compound interest on deposit accounts, motivating clients to save and enabling themselves to obtain money to lend to clients.

• Credit card accounts

In addition to high interest rates, banks charge compound interest on credit card accounts.  

Annual percentage rate (APR)

The annual percentage rate (APR) is the yearly rate of interest that a borrower must pay on a loan, or that an individual receives on a deposit account. Put differently, APR of a loan is the total amount of interest payable each year, indicated as a percentage of the loan balance. The APR differs slightly from the interest rate because it includes the interest rate plus any fees, such as an admin fee and the loan processing fee, involved in procuring a loan. It is an effective and useful benchmark when comparing loans. APR is applicable to, inter alia, mortgages, vehicle loans, and credit cards.  

The dynamics of interest rates in South Africa

The prescribed rate of interest

The prescribed rate of interest is governed by the Prescribed Rate of Interest Act (55/1975). Changes in the rate is published in the Government Gazette. The prescribed rate of interest is the maximum interest rate that a credit provider may charge with regard to interest-bearing debt. It is applicable to all debts unless a different rate is set by law, by trade custom or by agreement between the parties involved. The prescribed rate changes when the South African Reserve Bank (SARB) changes the repo rate, becoming effective from the first day of the second month following the month of the announcement of the new repo rate. As from September 1, 2026, the prescribed interest rate is 7% per annum.

Repo rate

The repo rate, short for repurchase rate, is the interest rate at which the SARB is willing to extend credit to the banks. The current (October 2026) repo rate is 7% per year. The SARB uses the repo rate to implement monetary policy, protecting the ZAR’s value, controlling inflation, and helping to stabilise the economy. The Reserve Bank has cut the repo rate from 10% to 7% since the start of the Covid-19-lockdown in March 2026.

Bank interest rates

Normally, banks add 3.5% to the SARB’s repo rate to determine the prime interest rate at which they charge clients for borrowing money from them. Basically, the mark-up covers their basic profit margin. Depending on a client’s risk profile, the prime rate is kept the same or adjusted up or down. As of October 2026, the prime rate is 7%.

Interest rates governed by the National Credit Act

The prescribed rate of interest can be avoided by credit providers by agreeing to a different interest rate, subject to other applicable laws such as the National Credit Act (43/2005). Regulation 42(1) of the Credit Act limits the amount of interest that can be charged. Regulation 42(1) is amended from time to time to adjust the maximum interest rate limits applicable to different credit types. Typically, the interest rates charged on debts such as credit card accounts and personal loans, are classified under this type of interest rates.

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