Interest rates are discussed a lot in personal finance. Understanding what interest is, how it works, and what makes a rate good or bad will help you make smart financial choices.
What is an interest rate?
The easiest way to understand interest is to look at it as the cost of borrowing money. The higher the interest rate, the more money will be added to the original amount borrowed.
We often think of interest rates as a bad thing; extra money owed to credit card companies or on car loans and mortgages. In these cases, you want a low rate, so you don’t have to pay too much extra.
However, interest rates also apply to your savings — which are, in effect, a loan you’re extending to the bank — but in this case, a high rate is preferable since you’re the one earning interest.
» MORE: What is compound interest?
What is a prime rate?
Interest rates can fluctuate regularly and are strongly influenced by what is known as the 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. If you have a variable-rate loan, you’ll see a difference in the interest you pay right away. However, changes in the prime rate also affect how much interest banks and other lenders charge for new or refinanced fixed-rate loans.
» MORE: What’s the difference between a fixed and variable-rate mortgage?
So, who sets the prime rate? Each bank will set its own prime rate, but the big Canadian banks — BMO, Scotiabank, CIBC, RBC, National Bank, and TD — usually have the same prime rate. This rate is determined in part by the Bank of Canada (BoC) overnight rate.
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.
However, the overnight rates are not the only thing that influences the prime rate. 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?
Right now, that makes Canada’s prime rate 5.95%. The prime interest rate in Canada is calculated as a mode average of the six big banks’ official prime 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 right after the BoC announces a change.
Types of products with interest rates
Many financial products in Canada have interest rates applied, including the following:
- Auto loans
- Personal loans
- Student loans
- Credit cards
- Savings (and some chequing) bank accounts
- Investment products, like guaranteed investment certificates (GICs)
- Tax-Free Savings Accounts (TFSAs)
- Registered Retirement Savings Plans (RRSPs)
These products may also have fixed or variable options, but, regardless, a change in the prime rate will eventually impact the interest rates on these products.
What makes an interest rate good or bad?
We often think of low rates as good, 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 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, which can be especially problematic if interest rates increase while you are still paying off the debt. To help ensure you get the best rates as a borrower, stay on top of all payments, try to avoid excessive debt, and make sure you have a healthy credit score.
As a saver, you want to see high interest rates so you can get further ahead. This concept is especially important for individuals who are older/retired and/or risk-aversive because they tend to invest in interest-bearing assets that have guaranteed returns. In these cases, low interest rate environments would prevent them from having the necessary savings and income for retirement.
Both borrowers and savers should shop around for interest rates to find the best deals and remember to keep an eye on inflation.
The BoC meets eight times a year, though they don’t usually change rates at these meetings. Sometimes, the BoC will go a couple of years without changing its overnight rate.
Other factors that may influence the interest rates offered to you include the amount of money borrowed, the length of time the money is borrowed, and your credit score and history.
Interest rate is just the rate of interest. The annual percentage rate (APR) includes all the fees from the lender plus the interest charges 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.
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