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Understanding Interest Rates

Last modified: 31 March 2010

What is interest? What is the rate of interest?

Quite simply, interest is the cost of money. The rate of interest is the cost of using someone else's money. When it comes to interest rates, Canadians are pulled in two directions: people who save and invest money expect a good return on their investments, or people who borrow money to buy homes, cars, businesses etc, want the lowest possible interest rates.

Interest Rates and the Economy

What affects the interest rates?

There are many factors. They include the money supply, the rate of inflation, the length of time the funds are borrowed, and the Bank of Canada's monetary policy.

What is the Bank of Canada?

The Bank of Canada's main role is to set the bank rate, which is the rate of interest it charges major financial institutions when they borrow money. While the Bank of Canada rate does influence the pricing of very short-term commercial credit, it does not set the interest rates that consumers receive on their deposits, or pay on their loans.

What makes interest rates go up and down?

There are several factors, including rates of inflation, market forces, monetary policy and the demand and supply of money in the economy.

For example: when more people want to borrow money than invest money (which means less money to lend) the price of borrowing will go up. As a result, interest rates increase. This in turn prompts people to invest more, because they will accumulate greater interest. When more people want to invest than to borrow, interest rates go back down.

Many people think that the interest rate that banks charge for fixed-rate mortgages and loans is driven by the Bank of Canada’s overnight rate. In fact, this is not true. While the Bank of Canada rate does influence the pricing of very short-term commercial credit, longer-term fixed rates are more affected by factors other than the Bank of Canada Rate, such as prices in the bond market, the costs of longer-term deposits, and generally the competition for funds in the financial markets.  

What Borrowers Want to Know

I'm shopping for a loan. What will affect the interest rate I pay?

Term of the loan: Is it short or long term? Short-term loans (overnight or up to a year) normally have lower interest rates because it's easier for the lender to predict future market conditions like inflation and economic growth.

Lenders tend to charge higher interest rates on long-term loans because they are taking a risk on future economic conditions. If they don't protect themselves against rising interest rates set by the Bank of Canada, they can lose money on the loan in the long term.

Risk: The more lenders feel there's a risk - the likelihood that the loan will not be repaid - the more they'll charge you for interest to compensate for that risk. They ask: What is your credit rating? What is your record of borrowing and repayment? Do you have a history of making your payments on time?

Inflation: Inflation refers to the general increase in prices. Inflated prices mean that money is not as valuable and lenders are concerned about prices increasing in the future.

For example: A bank loans you $2,000 today and over the next year prices increase by 5 per cent. When you repay the $2,000 a year from now, its purchasing power will be less. In essence, you'll be repaying cheaper dollars than the ones you borrowed. So lenders add an assumed inflation rate into the interest rate you will pay.

You can't influence some of these factors, but you can have an influence on factors such as risk by having a good credit rating.

How can I get the lowest rate of interest?

  • Shop around. Find the best rate for your needs.
  • Don't be afraid to ask for a lower rate than is quoted. Remember that the posted loan rates are only guidelines.
  • If you're not happy with the rate your financial institution quoted, check around to see what other lenders are offering. Your choices include: banks, trust companies, credit unions, caisses populaires and government lending institutions.
  • Maintain a good credit rating - pay back your debts and pay them on time. This could give you additional leverage when negotiating a loan.

What Savers Want to Know

What kind of investments or savings can I earn interest on?

You can invest your money in many different ways. Here are some examples:

  • Guaranteed Investment Certificates (GICs) and term deposits 
  • Mutual Funds
  • Stocks
  • Canada Savings Bonds
  • Bank accounts

What to consider when making effective savings/investment decisions

  • Your goals, needs and expectations: Will you need your money sooner rather than later? Do you need your money to be accessible? Is it worth borrowing for investment purposes? Do you need a flow of income?
  • What level of risk are you willing to take with your money? You can divide your money between higher risk investments and no risk investments.
  • The length of time you want to save/invest: If you choose a long-term deposit that will remain untouched for a long period, you'll usually get a higher interest rate than for short-term investments.

As a saver/investor, am I better off when interest rates are high?

Not necessarily. You have to figure out what you're really earning after inflation (ongoing increase in the price of goods and services).

For example: if interest rates are 18% and inflation is 15%, you're really only earning 3% (before taxes). But if interest rates are 6% and inflation is 1%, you are earning 5% (before taxes).

So you see, sometimes you're better off to invest when interest rates and inflation are low. The key is to always keep an eye on the "Big Picture".

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