What is an interest rate? At the basic level, an interest rate is a percentage of money that is added on top of the principal. This can either be paid out to you (as is the case with savings accounts) or charged to you (which happens when you’re borrowing money).
While loan interest rates and savings interest rates are similar, they’re also notably different. In this post, we’ll look at what an interest rate is in the context of savings accounts and loans.
What is an interest rate on a loan?
In the case of loans, an interest rate is the extra amount a lender charges a borrower when they lend them money. The borrower will pay the primary loan amount PLUS the interest rate amount when the loan is due.
For example, if you take a $1,000 loan, the borrower can charge a 10% interest rate. This means that upon repayment, you won’t just pay $1,000 but also $100 – which is 10% of $1,000. The total amount you’ll pay is $1,100.
Loans with interest rates include:
- personal loans,
- credit cards,
- lines of credit,
- home equity lines of credit (HELOCs), or
- mortgages.
What is an interest rate on a savings account?
In a savings account, banks pay you an interest rate on your savings. It’s usually calculated daily and paid monthly.
Banks that offer interest rates can sometimes demand that customers have a minimum amount in their accounts. So long as you don’t touch the money, you get rewarded with extra cash upon maturity.
For example, a bank may offer 5% interest on your balance. If you keep $2,000 in the account for a year, you’ll have $2,100 in total. That’s an extra $100, and you’ve done nothing apart from leaving money in your account. You can leverage this by using the best savings accounts in Canada.
You may also encounter banks that pay you a tiered interest rate. That means you get a certain amount of interest depending on how much you have deposited into your account.
Keep this in mind when choosing the right savings account for you.
Good vs. bad interest rates
The best interest rates are often from bank savings accounts and GICs. For bank savings, all you have to do is deposit money into a certain account and you’ll start accruing interest at the bank’s current rate. They’re ideal because you have easy access to the money at all times, plus your balance is protected by CDIC.
Better than savings account interest rates are GICs. With GICs, you have a 100% guarantee your money is safe and that you’ll earn a certain amount of interest for the duration of the term (whereas savings account interest rates can change at any time).
Typically, the longer the investment duration, the higher the interest rate.
With the above, it’s clear that you can profit via interest rates by simply making suitable investments. However, you can also lose money via interest rates when you make bad choices. This is typical with credits and mortgages.
For example, assuming you get a credit card, you usually have to pay an interest rate of around 20% per year. Therefore, if your monthly credit card spending is $1,000, and you don’t pay off your balance on time, you have to pay $1,020 – $1,040 instead. Higher interest rates on credit products can make borrowing more expensive and in the long run, such interest rates can cause big financial problems, possibly even leading to bankruptcy.
Simple interest rate vs. compound interest rate
There are 2 main types of interest rates – simple interest rate and compound interest rate.
- Simple interest rate: As the name suggests, a simple interest rate is straightforward. You only have to pay the fixed interest percentage on the principal amount. It’s the most common type of interest rate you’ll find.
- Compound interest rate: A compound interest rate, on the other hand, is more or less an accumulative interest rate. This is because you don’t pay the interest rate on the principal amount only, but also on the interest rate of the previous interest amount.
With compound interest rates, the lender earns a lot more than with simple interest rates.
How to calculate interest rates
Calculating an interest rate will depend on whether it’s simple or compound.
For a simple interest rate, the formula is:
Simple Interest = P*I*N
Where:
- “P” is the principal amount,
- “I” is the interest rate percentage, and
- “N” is the duration (in years).
Let’s assume you borrow $500 at a 10% interest rate and have to pay it back in 2 years. Using the simple interest formula, the interest you’ll pay is:
$500 x 10% x 2 = $100
The total amount you’ll pay is $600.
For the compound interest rate, the formula is:
Compound Interest = P[(1+r/n)^(n*t)-1]
Where:
- “P” is the principal amount,
- “r” is the interest rate,
- “n” is the number of compounding periods, and
- “t” is the duration.
Using the compound interest formula for the same example above, the interest you’ll pay is:
$500 x [(1 + 10%) ^ (2) – 1)] = $105
The total amount you’ll pay is $605.
How are interest rates set?
The biggest factor impacting interest rates is a bank’s prime rate. Prime rate is based on the overnight rate set by the Bank of Canada, which is what financial institutions are charged to borrow money. This then informs what banks set as their prime lending rate – the rate they use to set interest rates on products such as mortgages, loans, and even savings accounts and GICs.
Other factors that influence interest rates include:
- your personal credit history,
- income,
- the length of term,
- collateral,
- type of loan,
- supply and demand,
- inflation,
- etc.
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Understanding interest rates in Canada
Does your bank offer interest rates? If so, know it’s a good opportunity to earn extra cash. However, if you take credit loans, ensure you watch your spending, so you don’t incur high interest rates.
Let us know your experience with interest rates – good and bad – in the comments below.
FAQ
What is an interest rate and how does it work?
An interest rate is an extra amount a lender gets from a borrower. It’s a percentage of the principal amount.
What is the average interest rate on a savings account?
Not many big banks offer high rate savings accounts anymore, but if you turn to online banks, you’ll be able to find more options. Right now, most savings accounts in Canada are offering around 2% interest, with some reaching close to 4%.
What is the highest interest rate savings account in Canada?
At the time of publishing, the Motive Savvy Savings Account has the highest interest rate at 2%.
What is the prime interest rate Canada?
Current data shows that the prime interest rate in Canada is 4.45%. Banks and financial institutions consult this rate when setting their individual interest rates.
What is interest rate vs. APR?
An interest rate is the cost of borrowing charged or earned as a percentage of the principal. The Annual Percentage Rate (APR) usually applies to loans and it includes the annual interest rate and any additional fees. For this reason, the APR on a loan is usually higher than the interest rate.
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