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Financial Literacy: How interest rates work

Financial Literacy Series: What interest rates are and how they affect your life

While watching the news, you’ve likely noticed that interest rates are falling. For some people, this just ends up being background noise, and they pay little attention to it. However, interest rates are a significant factor when it comes to your daily finances and your bank account, which is why it’s important to know how they work.

With November being Financial Literacy Month, it’s the perfect time to demystify the concept of interest rates. When you see how simple it is, you can make smarter financial decisions for yourself—and more easily follow the evening news.

What is an interest rate?

An interest rate is the amount a lender charges as a percentage of the principal in order to borrow money. That amount, along with the money you borrowed, would be paid back in the future, over time. Typically you’ll see an interest rate noted on an annual basis, which is called the annual percentage rate, or APR.

Although interest rates are typically associated with borrowing money, it can also apply to saving money. Banks are essentially borrowing from you when you deposit money and some of them will pay you for it.

What is the Bank of Canada overnight rate?

The Bank of Canada (BoC) sets the overnight rate, often referred to as the prime rate. Think of the prime rate as a benchmark lenders use to determine the interest rates for loans and lines of credit.

For example, a lender may provide you with a mortgage that comes with a fixed interest rate of 2.50% with a term of 5 years. Alternatively, your bank might quote you prime plus 2.75% as the interest rate for a line of credit.

Why are some interest rates so high?

Although the prime rate acts as a benchmark, the amount of interest you pay depends on the reason you’re borrowing. For example, a credit card is an unsecured loan which is why the interest rate can be 20% or more. Whereas an auto loan is a secured loan, so the lender would get something back if you defaulted on your payments. Since secured loans have collateral, lenders may offer lower rates.

Your credit score also factors into interest rates. Generally speaking, the higher your credit score, the better interest rates you’ll get. The reason this occurs is that lenders may be worried about your ability to repay the loan. They may charge you a higher rate because they’re taking on additional risk.

Why have interest rates dropped during the pandemic?

In Canada, interest rates are impacted mostly by inflation, which is the increase in the price of goods and services. “The goal of the Bank of Canada is to keep inflation around 2%,” says Jason Heath, a Certified Financial Planner at Objective Financial Partners Inc. “The bank decreases interest rates when inflation expectations are low.”

Low rates would encourage borrowing and spending, which is why the BoC made three quick cuts of 0.5% to get to the current rate of 2.45% since the start of the COVID-19 pandemic. This will hopefully lead to increased economic activity.

How can interest rates affect you personally?

Changing interest rates affect you in multiple ways, but the most common scenario is home affordability. Let’s say you’re in the market for a home, and you are preapproved for a $400,000 mortgage with a fixed interest rate of 3.5%. Using a mortgage calculator, your monthly payment would be $1,997. While you’re searching for a home, the BoC slashes rates, and fixed-rate mortgages are now available for 2%. As a result of this cut, your monthly payments would now only be $1,694.

Low rates can increase the amount you qualify to borrow. But that may not necessarily be a good thing. “One challenge with low interest rates is debt has become much more acceptable in recent years,” says Heath. “Many people think in terms of what they can afford in monthly payments, as opposed to taking a long-term view.”

On the other hand, low interest rates can be beneficial to people who have any outstanding debt. If you have any debt at a higher interest rate, such as credit card debt or an auto loan, it could be worthwhile to refinance or get a line of credit. With the lower interest loan you would pay off your higher interest debt, which could save you money in the long run.

For those who love to save, low interest rates can work against you. When you deposit money in a savings account, you’re lending the bank money. The interest rate they pay is dependent on the overnight rate set by the BoC. When rates are low, you’ll earn less interest.

Can interest rates go up?

The prime rate can go up and down depending on the goals of the BoC. The rate peaked in 1981 at 22.75%, but has mostly been on a downward trend for the past 40 years.

More recently in 2007, the Canadian prime was at 6.25%. That’s a significant difference from the the 2.45% prime rate that we’re seeing now.

“Young people who have just taken on their first mortgages in the past ten years can’t fathom a mortgage rate over 5%,” says Heath. “Many of their parents had double-digit interest rates for many years.”

Interest rates will eventually go back up, but that may not happen until at least 2003 . When that time comes, the cost to service your debt will go up, which may affect your spending.

Low can be good—but think about your goals

When interest rates are low, you have an incentive to borrow. But that doesn’t necessarily mean you should spend more. Having more debt means you owe more money and your monthly expenses could be higher.

If you’re borrowing for things such as consumer goods, you may be neglecting your short, medium, and long-term financial goals, such as saving for retirement or paying for your child’s education.

Low interest rates and debt can work to your advantage when used responsibly. But always think about your overall financial health when you’re about to borrow.

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