Interest Rates 101
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Interest rates have an important role in our financial market; they indicate the cost of lending. In other words, interest rates provide incentive 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 (what is good debt? learn here) 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 bad debt. It’s important for all Canadians to understand how interest rates are calculated before they make any decisions about applying for loans or credit. This article will provide basic information to help you understand the general aspects of interest rates.
Fixed Rate vs. Variable Rate
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.
A fixed interest rate refers to an interest rate that will not change during the complete duration of your loan agreement. This means that you will maintain the same interest rate as your payments go by and until your loan is completely paid off.
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 to know 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 the 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.
Variable (or Floating)
The second form of interest rate is the variable rate. As its name implies, this is a rate that will change as your payments go by. The variable rate moves according to the market premium, when the market interest rate shifts so will your interest rate , 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 financial 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 stable and rarely fluctuate; this can be a great way of getting a lower interest rate without too much risk
For example, 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). An annual percentage rate represents the percentage of interest you’ll pay on your loan over one year. For example, if you have a 5% interest rate (APR) on $10,000 loan, you will pay 500$ 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 $30 activation fee. As per the calculation bellow, you are currently paying a 23% interest rate on a three month loan. Let’s now find out what your APR is. The easiest way to calculate this is by firstly, finding the monthly rate and then multiplying it by 12 months. In this case, the monthly rate is 7.67% and the yearly rate is 92%.
( (430+ 400+ 400)-1000)/1000) = 23% interest for 3 months
23% / 3 months = 7.67% per month
7.67% x 12 months= 92% per year
Interest Rate (term)= (Total payments – Loan amount) / Loan amount
Interest Rate (monthly)= Interest Rate (term) / Amount of months/weeks
Interest Rate (yearly)= Monthly Interest Rate x 12 months
Interest Rate Legal Limits
In our last example, the APR was 92%, in Canada this is over the legal limit. In fact, the legal limit for Canadians is at most, 60% APR including fees and charges. There is an exception to this legal limit, the payday loan industry is regulated provincially and has different legal limits.
A payday loan is a last resort loan in which you borrow an amount of money you must repay by your next payday; this is typically a two week period (learn more about payday loans and the cycle of debt they create). Payday lenders charge high interest rates and fees to their customers in order to make short term profit. Here is a chart presenting the legal interest rate limits allowed for payday loans per province.
Legal limit for a 100$ loan with a 2 week term
Prince Edward Island
Understanding interest rates can help you make better financial choices. It will help you build your 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 rate 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.
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Margaret Johnson is in the business of helping Canadians tackle their debt, deal with credit issues, and regain control of their finances.