If you're considering taking out a loan, applying for a new credit card, or investing in a guaranteed investment certificate (GIC), you must understand how interest rates work. Interest is a key part of many financial transactions and investments and understanding what it is and how it accrues is vital to financial health. Below, we run through the basics of interest rates, including how they work, how to pay interest, and how interest is earned.
What is interest?
In basic terms, interest is the cost of borrowing money, which is why when interest rates are low, people say "money is cheap." When you borrow money from an institution, such as a bank, you not only have to repay the money you borrowed but you have to pay interest on it. Interest rates vary widely and are influenced by a number of factors, ranging from economic conditions and the stock market to government programs and the Bank of Canada rate. For this reason, interest rates are constantly fluctuating.
Anytime you borrow money from a financial institution, you will need to pay interest. Interest rates are listed as percentages of the total amount of money borrowed. Each month, interest at the agreed-upon rate is applied to the amount you still owe. Therefore, in most cases, the faster you can pay off your loan, the less money it will cost you in interest. When determining your interest rate, a lender will evaluate your ability to pay the money back by examining your credit history, net worth, gross household income, and more.
Though most people think of interest as something they have to pay, it's possible to earn interest as well. For example, when you deposit money in an interest-bearing account, you can earn interest on the amount of money you hold in that account. You will also earn interest on certain investment products like GICs, where the interest is accrued over the GIC term. Most GICs pay interest annually or upon maturity, but some, like escalating-rate GICs, may pay you more frequently and at varying rates.
Why do interest rates change?
As mentioned above, several factors influence interest rates, which is why they are constantly fluctuating. Generally speaking, when you receive word that interest rates have gone up or down, it's usually because the Bank of Canada has changed its overnight rate (an overnight rate is the rate at which banks lend money to one another at the end of the business day). Changes to the overnight rate can directly impact the interest rates offered by financial institutions. For this reason, the Bank of Canada has the power to significantly influence the economy. As an example, if inflation rates are rising too fast, the Bank of Canada can increase its interest rate to incentivize people to save money rather than borrowing it or spending it. In contrast, the Bank of Canada might reduce interest rates if the economy needs a boost, as lower interest rates typically translate to an increase in loans and spending.