It’s important to understand what interest is, how it works, and its impact on your financial wellbeing in order to reach your financial goals. However, only 62% of Canadians understand the impact of interest rates on their debt and nearly 50% have less than $200 wiggle room each month to account for increasing interest rates. This article will teach you what interest is, how it works, and how it impacts your savings, credit cards, mortgages, and more.
What is interest?
In simple terms, interest is the cost of borrowing money. When a lender provides a loan, you pay interest on top of the original loan amount. Similarly, when you deposit money in a savings account, you are lending money to the bank and receive interest in return, which is your profit. Interest rates affect the amount of interest you will pay on mortgages, auto loans, credit card debt, student loans, and other types of debt.
There are two types of interest: simple interest and compound interest. Simple interest is only charged on the original principal amount, while compound interest is charged both on the principal amount and the interest already accrued. For example, a loan of $1000 with a 5% annual interest rate for 3 years will result in interest payments of $50 each year with simple interest. Whereas, using compound interest payments would be $50 the first year, $52.50 the second year, and $55.13 in the third year.
How are interest rates determined?
Each type of loan has its own average amount of interest, which is determined based on a number of factors. These factors include: the principal amount (the amount you take out initially), the length of the loan term, the repayment schedule, monthly payment amounts, the borrower’s credit-worthiness, and market factors.
Market factors, such as the state of the economy, heavily influence the interest rate set by banks. A country’s central bank, such as the Federal Reserve in the U.S. and the Bank of Canada, sets the interest rate which each bank uses to determine their rates. A high interest rate increases the cost of debt, discouraging people from borrowing and slowing down consumer demand. Consumers resort to saving their money due to the interest they will earn on savings accounts. In contrast, low-interest rates help stimulate an economy by encouraging individuals and businesses to spend and buy riskier assets such as stocks rather than using savings accounts. These rates are intended to control inflation.
Consumer loans often use the annual performance rate (APR) to determine the actual interest rate a consumer pays. The APR is the amount of interest you will pay over the course of a year, including extra loan processing fees. Typically, the APR is 0.1% to 0.5% higher than the interest rate and is often a more accurate indicator of how much interest you will pay when comparing loans.
How does interest work on different debts?
Mortgages
Mortgages are one of the only loans not directly affected by the interest rate set by the central bank. Instead, mortgage rates are influenced by investors who buy bonds and mortgage-backed securities. Rates are also determined based on the buyer’s credit worthiness, as those with higher credit scores typically receive lower interest rates. Over the past 40 years, the average mortgage rate has fluctuated between 3.56% and 16.64%, so it is important to do some research before taking out a mortgage loan to determine if it’s the best time to buy.
Credit Cards
Credit cards have much higher interest rates than other loan types to offset the losses to banks if the borrower defaults. Compared to auto and home loans for example, lenders have no collateral to collect in the event a borrower defaults on their credit card. Therefore, the average credit card rate is 14-24%.
Auto Loans
Auto loans use your car as collateral, so in the event you miss any payment they can repossess the car to cover the costs of the loan. Due to their ability to collect collateral relatively easily, auto loan interest rates are typically 4-5%.
Payday Loans
A payday loan is a small, short-term loan used when you need money immediately and intend to repay the loan when you receive your next paycheck. Typically, payday loans have very high interest rates to encourage quick repayments. For example, for a loan of $100 with a repayment due in 2 weeks, the APR could be around 400%.
Savings Accounts
Individuals can earn interest by depositing funds in a savings account. As an incentive for keeping your savings with a bank, you can receive interest on your savings. Typically, this rate is much smaller at 1-2% since the bank is paying you rather than making money from your interest.
Although interest payments may feel like a step backwards, borrowing money offers many financial and life opportunities when correctly managed. If you stay on top of your payments and take advantage of favourable interest rates, you can use these loans to your advantage.
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