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Published February 8, 2024
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6 minutes

What Is an Interest Rate?

An interest rate can be thought of as the cost of borrowing money, or the income you earn on saved money.

Understanding what interest is, how it works and what makes an interest rate good or bad can help you make smarter decisions about loans and investments.

Understanding interest rates

A simple definition of “interest rate” is the cost of borrowing money. When interest is charged on a loan, it means you’ll have to pay back more than you borrowed.

But interest rates also apply to your savings — which are, in effect, a loan you’re extending to the bank. When interest is offered on a savings account or investment product, like a guaranteed investment certificate, it means you’ll be paid out more than you deposited.

How are interest rates determined in Canada?

Interest rates can fluctuate regularly. Inflation, market conditions and Bank of Canada policy changes are some of the broader factors influencing individual bank rates in Canada. 

BoC’s overnight rate, also known as the policy rate, is one of the key elements that guides the prime rates for commercial banks. Each bank sets its own prime rate, but the Big Six Canadian banks — BMO, Scotiabank, CIBC, RBC, National Bank, and TD — usually have the same prime rate. 

This number also shifts but is considered the reference point for interest rates on several different types of loans, including mortgages, home equity lines of credit (HELOCs), car loans, and some types of credit cards. As the prime rate changes, so do the rates of interest charged on these types of loans.

The BoC typically increases the overnight rate when inflation exceeds 3%. The Bank may cut the overnight rate if it’s concerned that inflation will fall below 1%. When the overnight rate increases, it’s more expensive for banks to borrow money. So the banks subsequently raise their prime rates to help cover costs by charging clients more interest. 

Similarly, when the BoC drops the overnight rate, banks will often lower their prime rates. Additionally, things like the bond market, costs of long-term deposits, and competition for funds also play a role in determining the prime rate.

What is the prime interest rate in Canada?

As of Feb. 8, 2024, Canada’s prime rate is 7.20%. The prime interest rate in Canada is calculated as a mode average of the Six Big banks’ official prime rates and normally rises or falls right after the BoC announces a policy rate change.

How often does the prime rate change?

The prime interest rate in Canada is influenced by the Bank of Canada’s policy rate. The Bank has scheduled meetings on eight fixed dates each year. It’s during these meetings that any policy rate adjustments are typically announced. 

Types of interest rates

As said earlier, the banks determine their prime rates based on the overnight rate as determined by the BoC. The BoC typically increases the overnight rate when it is worried about inflation exceeding the upper limit of 3%. It cuts the overnight rate if it is concerned that inflation will fall short of the 1% floor. The prime rate normally rises or falls accordingly, after the BoC announces a change.

Prime rate changes impact the interest rates on numerous financial products, regardless of the type of interest associated with them.

Here are some of the interest rate types you might encounter while shopping for loans, credit cards, savings accounts and investment products.

Fixed rate 

A fixed rate of interest implies that your interest rate will remain the same throughout the duration of the loan, savings or investment product’s term. Although fixed rates are tied to the bank’s prime rate, the interest rate is locked during the agreement. 

Fixed rates are ideal for borrowers who like being in control by estimating their loan’s total cost and making timely repayments. Fixed rates are also a preferred form of interest for risk-averse savers who worry about market fluctuations and prefer knowing the exact return on their investments. 

Variable rate 

A variable rate refers to an interest rate that’s tied to — and changes with — the bank’s prime rate. 

Variable interest rates work for borrowers who want to benefit from the market conditions to keep the loan cost low when rates dip and are willing to risk it if interests rise. Similarly, they’re ideal for investors who want to make the most of the high-interest earnings and don’t mind a few hits due to poor financial market hiccups.

Annual percentage rate

An annual percentage rate (APR) includes interest charges and all the fees from the lender that you will pay in one year. If the APR is much higher than the interest rate, you know the lender’s fees are high.

Annual percentage yield

The annual percentage yield (APY) is the interest income on your savings over a year. It’ is also known as earned annual interest (EAR).

Simple interest

Simple interest is calculated using only the principal amount. The interest rate is usually included in the agreement. 

Compound interest

Compound interest is calculated using the principal, as well as any accumulated interest income or charges. While compound interest may be a lucrative concept to grow savings, it can have an adverse effect when borrowing money.

What makes an interest rate good or bad?

We often think of low interest rates as good and high interest rates as bad, but this isn’t always the case. It depends on whether you are looking at the interest rate as a borrower or as a saver.

As a borrower, lower simple interest rates are ideal because they make things like financing a car or home more affordable. At the same time, however, low interest rates may lead you to take on more debt than you can afford. Such a situation can be especially problematic if interest rates increase while you’re still paying off the debt. 

To help ensure you get the best rates as a borrower, stay on top of all bill payments, try to avoid excessive debt and maintain a healthy credit score

Financial products that typically charge interest on the principal amount include:

As a saver, you want to see high compound interest rates so your money will grow faster. Seeking the highest-possible savings interest rate is especially important for individuals who are older, retired, risk-aversive or all three. This is because they tend to invest in interest-bearing assets that have guaranteed returns. 

Interest-earning savings and Investment products include: 

Both borrowers and savers should shop around for interest rates to find the best deals — so long as they remember to keep an eye on inflation.

Frequently asked questions about interest rates

What are interest rates?

Put simply, interest rates are charges you pay for borrowing money through loans and mortgages. However, interest rates also apply to your savings. When you deposit or invest money, the bank pays you interest for lending it those funds.

How do interest rates work in Canada?

Interest rates in Canada are determined by market conditions, inflation, costs of long-term deposits, competition for funds, and Bank of Canada policy. The two main interest rate types you might encounter while shopping for loan and investment products are:

Simple interest, which is calculated using only the principal amount.

Compound interest, which is calculated using the principal, as well as any accumulated interest income or charges.

DIVE EVEN DEEPER

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