Interest Rates 101

It’s very common for people to not understand what exactly an interest rate is and how it can affect your financial life. Interest rates have an important role in our financial market; they indicate the cost of lending. In other words, interest rates provide incentives for lenders to provide us with the loans we need and want. The higher the interest rates are, the more profitable it is for lenders to provide loans and other financial products. In turn, loans offer countless possibilities for borrowers to wisely spend and invest. Simply put, this type of spending creates good debt and can lead to prosperous economic growth. 

On the other hand, excessively high-interest rates can have a negative impact on economic growth as they often create high levels of debt. It’s important for all Canadians to understand how interest rates are calculated and how interest rates work before they make any decisions about applying for loans or credit.

Fixed Interest Rates vs. Variable Interest Rates

Generally, most loan products offer two types of interest rates to borrowers, fixed or variable. Depending on your financial needs, one may be more beneficial than the other. 

Fixed Interest Rates

A fixed interest rate refers to an interest rate that will not change during the complete duration of your loan agreement or in the case of a mortgage, the length of your loan term. This means that you will maintain the same interest rate as your payments go by and until your loan is completely paid off or you come to the end of your term. 

Organizing your finances is key to having healthy financial habits as they will help you build a great credit score and allow you to access a variety of different financial products. The best way to organize your finances is by knowing the exact amount of money you have to pay. Fixed interest rates can help you anticipate your payments and make sure you have enough money to pay them.  

A Fixed interest rate is calculated by financial institutions in the same way the variable rate is calculated. It can be broken down into two parts: the market premium rate and your own risk premium. The first one is a base that depends on the market’s position; we can think of this as the basic cost of lending. Your risk premium is based on your financial history; this is usually found in form of a credit score. Your risk premium is a percentage that will cover the lender in case you are unable to pay back your loan. 

Check out how fixed and variable rates can affect a mortgage. 

Variable or Floating Interest Rates

The second form of interest rate is the variable rate. As its name implies, this is a rate that can change on a monthly basis. The variable rate moves according to the market premium, when the market interest rate shift your rate will change, it can either be positive for you (a lower interest rate) or negative (a higher interest rate). When you negotiate your loan agreement, your risk premium will be given to you in the same way as in the fixed-rate, based on your credit history. With a variable interest rate you are sharing part of the risk with your lender therefore they will offer you a lower interest rate when you first get your loan. 

A variable-rate can be a great option when you are applying for a short-term loan. In Canada, interest rates are relatively stable and rarely fluctuate; this can be a great way of getting a lower interest rate without too much risk 

For example, let’s say the market premium is 3% and your own risk premium is 2%, this means that for the first month your variable rate will be 5%, in the case that the market premium drops to 2% your interest rate for the following month will 4%. It is important to consider that the market can shift positively or negatively. 

Annual Percentage Rate (APR)

There are several different ways to display interest rates. When signing a loan agreement, your interest rate can be calculated on a daily basis, monthly or more commonly on an annual basis. In fact, it is legally required in Canada for any loan agreement to display the annual percentage rate (APR). Showing the APR makes it easier for borrowers to compare interest rates between them. An annual percentage rate represents the percentage of interest you’ll pay on your loan over a year. For example, if you have a 5% interest rate (APR) on a $10,000 loan, you will pay 500$ of interest rate in a year. 

Here is another example that may help you understand how you can transform your interest rate into an APR format.

Let’s say you have a 3-month loan of $1000, every month you have to pay $400 and there is a $30 activation fee. As per the calculation below, you are currently paying a 23% interest rate on a 3-month loan. Let’s now find out what your APR is. The easiest way to calculate this is by firstly, finding the monthly rate and then multiplying it by 12 months. In this case, the monthly rate is 7.67% and the yearly rate is 92%.

( (430+ 400+ 400)-1000)/1000) = 23% interest for 3 months

23% / 3 months = 7.67% per month

7.67% x 12 months= 92% per year

Formulas:

Interest Rate (term)= (Total payments – Loan amount) / Loan amount

Interest Rate (monthly)= Interest Rate (term) / Amount of months/weeks

Interest Rate (yearly)= Monthly Interest Rate x 12 months

Interest Rate Legal Limits

In our last example, the APR was 92%, in Canada this is over the legal limit. In fact, the legal limit for Canadians is 60% APR including fees and charges. There is an exception to this legal limit, payday loans. The payday loan industry is regulated provincially and has different legal limits. 

A payday loan is a last resort loan in which you are lent an amount of money you must repay by your next payday; this is typically a two week period. Payday lenders charge high-interest rates and fees to their customers in order to make short-term profit. Here is a chart presenting the legal limits allowed for payday loans per province. 

Thinking of getting a payday loan, make sure you know your rights and responsibilities.

Understanding interest rates can help you make better financial choices. It will help you build a healthy credit score while saving money in the long term. It is important for you to negotiate your loan agreements and search for the lowest possible rates. Make sure you are fully aware of the annual percentage rates you are being offered and compare them before you make any final decisions. Organizing your finances and building a budget will help you make the right choices when it comes to borrowing.