One of the most important lessons to teach your children about financial wellness is understanding the importance of interest rates, how they work, and how they impact daily life. Just like how you would explain to your kids how credit cards work, a solid understanding of interest is important. Below, we dive into interest rates in Canada, including what the different types of interest rates are and how they are determined.
Interest explained
Before we discuss interest rates, let’s begin with a general overview of interest.
Interest is the amount of money that a person is charged in exchange for being able to borrow money. In other words, it is the amount of money that a lender or bank will receive from a borrower for lending money to them. Therefore, when interest is charged on a loan, the borrower will end up paying back more money than they originally borrowed.
Interest is usually expressed as a dollar amount, though it can also be expressed as a percentage, such as when it is an amount of ownership that a stockholder has in a company. Interest may be charged and paid to a wide variety of lenders, including banks, credit unions, mortgage lenders, and more.
Ultimately, interest is designed as a form of financial security to protect lenders from risk. In exchange for a lender willingly sacrificing money to a borrower (taking on risk), they charge interest. The lender who is temporarily parting ways with their money receives compensation above and beyond what they are lending the borrower. Meanwhile, the borrower who receives the funds, otherwise unatainable, is able to use it for their needs like buying a home or car.
The amount of interest that a borrower is required to pay usually depends on their risk level or creditworthiness. The type of loan they are requesting, and the length of the loan term (by when it has to be repaid) will also come into play. Generally speaking, interest will be greater when the borrower is deemed higher risk (meaning they are less likely to make their payments) and it will be smaller when the borrower is deemed lower risk (likely to make their payments).
Interest rates explained
Where interest is the amount of money that a person is charged in exchange for borrowing money from a lender, the interest rate is the rate at which the interest is calculated and charged. Interest rates are usually expressed as an annual percentage rate (APR).
Interest rates apply to loans, as well as to a person’s RESP, TFSA or savings account. This is due to the fact that savings accounts act as loans, except in this instance, the account holder (aka you, the consumer) is extending the loan to the bank. The bank then goes on to use this money for other means. But in exchange, you will earn interest, resulting in a greater payout than the original money you deposited.
How are interest rates determined in Canada?
Interest rates in Canada are influenced by a number of factors including the economic market, inflation, and policy changes with the Bank of Canada (BoC), causing them to fluctuate frequently.
For example, the Bank of Canada’s overnight or policy rate plays a key role in determining prime rates for commercial banks. That said, each of Canada’s big six banks (BMO, Scotiabank, CIBC, RBC, National Bank, and TD Canada Trust) set their own rates, though they are usually the same as one another. Although the Bank of Canada’s overnight rate is one of the most significant factors in banks determining their prime rates, it isn’t the only factor. The bond market, the cost of long-term deposits, and competition for funds can also impact a bank’s prime rate.
The prime rates set by Canada’s major banks are viewed as a reference point for interest rates on a wide variety of loans, such as car loans, mortgage loans, and home equity lines of credit, among others. When prime rates at these banks change, so do the interest rates charged on these types of loans.
The Bank of Canada typically increases the overnight or policy rate when inflation in the country goes beyond 3%. Oppositely, the Bank of Canada might reduce the overnight rate if they are worried that inflation will fall below 1%. An increase in the overnight rate makes it more expensive for banks to borrow money, which is why it usually leads banks to raise their prime rates. Meanwhile, when the Bank of Canada reduces their overnight rate, it is cheaper for banks to borrow money and so they are inclined to lower their prime rates.
Types of interest rates in Canada
There are various types of interest rates in Canada, from fixed rates to variable rates. Below, we have made a list of some of the most common types of interest rates in the country, many of which you may encounter when shopping for a credit card, taking out a loan, or opening a savings account.
Fixed rate
A fixed interest rate means that your interest rate will stay the same throughout the entire term of your loan. For example, if you buy a two-year guaranteed investment certificate (GIC) that has a fixed rate, your interest rate will remain the same over the span of two years. This makes it easy to calculate how much interest you will earn on your investment at the end of the term.
While fixed rates are tied to the prime rates set by banks, they do not fluctuate during the term of your loan or investment. They are locked and cannot be changed. This makes fixed rates ideal for borrowers who are risk-averse and who prefer the safety of knowing how much they will owe or earn by the end of their loan or investment period.
Variable rate
The next type of interest rate is variable rate. A variable rate interest is tied to the bank’s prime rate, like fixed rate interest. However, unlike fixed rate interest, a variable interest rate changes as the prime rate changes. Thus, this type of interest rate is best suited to borrowers who are less risk-averse and who want to benefit from changes in the market if that prime rate drops.
Annual percentage rate
An annual percentage rate (APR) is another term that you will hear in regard to interest rates. An APR is the total amount of interest charges and fees that a borrower must pay to the lender over the course of a year. If the APR is significantly higher than the interest rate, this usually means that the lender’s fees are high.
Annual percentage yield
Annual percentage yield (APY), sometimes called earned annual interest (EAR), is the total interest that you have accrued on your savings over the course of one year.
Simple interest
Simple interest is another term to be aware of. This type of interest is calculated on the principal amount of the loan or investment and nothing else. The simple interest rate is usually clearly stated in the loan agreement.
Compound interest
Meanwhile, compound interest is a type of interest that is calculated on both the principal amount of the loan and the interest income or charges that have accumulated. One of the biggest benefits of compound interest is that it can allow you to grow your savings faster so that you can save more money for post secondary education or even a gap year (learn how to budget for a gap year here). However, it can also lead to greater financial trouble if you are borrowing money.
Good and bad interest rates
Many people mistakenly believe that low interest rates are good and high interest rates are bad, but it isn’t that simple. The first thing you need to consider when assessing an interest rate is whether it is being applied to a loan or a savings account. Interest rates have very different implications for borrowers versus savers.
A few examples of financial products that borrowers may be charged interest on include mortgage loans, car loans, personal loans, student loans, and credit cards. As a borrower, low interest rates are usually the best-case scenario because they make buying a home or financing a vehicle more affordable. That said, when interest rates are lower, borrowers may be more likely to take on additional debt, which can cause trouble down the road. If you want to reduce interest rates, learn the 3 ways to take the bite out of interest rates.
If saving is your objective, a higher interest rate is usually ideal because it allows your savings to grow faster. High compound interest is often the perfect combination for savers. A few types of financial products that savers or investors may be able to earn interest on include savings accounts, certain chequing accounts, tax-free savings accounts (TFSAs), registered retirement savings plans (RRSPs), guaranteed investment certificates (GICs), and other investment products.
If you want to start saving your money effectively, speak with a financial expert at Embark who can help you come up with an RESP plan that works for your household.
Embark is Canada’s education savings and planning company. The organization aims to help families and students along their post-secondary journeys, giving them innovative tools and advice to take hold of their bright futures and succeed.
