/ Published 9:14 AM EST / Rob Mann, Staff Writer

Interest rates 101: how interest works, and why it matters to you

“Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it." 
—Albert Einstein

 

In a recent survey, 60% of Canadians reported not understanding the impact of interest rates on their debt. In addition to that, over half of respondents said that they have less than $200 wiggle room each month, meaning if interest rates increase, they'll face some very tough decisions. And with interest rates at an all-time low in Canada, this is a huge cause for concern across the country.

Whether your financial situation is solid or you're vulnerable to market fluctuations, the importance of understanding interest and its connection to your financial wellbeing is crucial – and that's exactly what this blog is here to help with. We want to cover the different types of interest, how they work, and how they impact you, your money, and your life. 

Before diving into the specifics of how interest works in different situations, let's start with some basic terminology that will help you understand how interest affects your life.

• Principal: the base amount of money that you're either borrowing or investing.

• Term: the length of your loan or investment.

• Interest: the amount that you're charged for borrowing money or that you're given for keeping cash in your accounts. There are two types of interest: simple and compound:

Simple interest: simple interest is charged only on the original principal amount. For example, if you have $1000 with a 5% annual interest rate for 3 years, you'll earn $50 (5% of 1000) of interest per year, for a total of $1,150.

Compound interest: compound interest is charged on both the original principal amount, and any interest previously accrued. Plainly put, it's interest on interest. For example, let's look at that same $1000 with a 5% annual interest rate for 3 years with compound interest: your principal would earn $50 interest in the first year, but in the second year, you'd earn interest on the new total of $1050, which would be $52.50, then $55.13 in the third year, for a grand total of $1157.63.

• Interest rates & annual percentage rate (APR): the interest that you earn (or that you're charged) is based on the APR. Again, there are different ways of calculating the APR, which impacts the actual interest rate:

Nominal interest rate: this is the most basic type of interest rate. It's a flat interest rate paid on a loan. For example, if the nominal rate on $1000 is 5%, the total interest will be $50. The nominal interest rate is directly connected to simple interest, in that it's the flat rate charged for borrowing or lending money.

Real interest rate: the real interest rate is the nominal rate, adjusted for inflation. For example, if the nominal interest rate is 5%, and the inflation rate is 2%, your real interest rate is 3%. So on that $1000, the real interest earned would be $30.

Effective interest rate: the effective interest rate, is the rate with compounding taken into account. For example, if the interest rate on $1000 is 5% per year, compounded semi-annually (twice per year), you'd earn $25 after the first 6 months, then $25.63 in the second 6 months of the year. In that case, the nominal interest rate is 5%, and the effective rate is 5.06%.

• Prime: prime is the base interest rate that banks and lenders use to set their interest rates. In Canada, banks set their own prime rate, but it typically follows the lending rate set by the Bank of Canada. In the U.S.A., the Federal Reserve sets the prime rate.

Now that we're clear on the terminology, let's dig into how interest works with different types of loans.

Types of debt and interest

When it comes to borrowing money, there are several different types of loans and credit that you can take on. While it's never ideal to owe money, there are definitely good and bad forms of debt. Mortgages and student loans, for example, are examples of good debt. They're investments in your future that give you an asset that should benefit you for the rest of your life. Of course, things like credit cards and payday loans are considered to be bad debt due to their high interest rates. Here's an overview of the most popular types of loans, and how interest affects each of them.

Credit cards

One of the most common forms of debt that people take on is credit card debt. But as credit cards typically have some of the highest interest rates, it's important to understand how they function.

Nearly every credit card on the market has a grace period of 21 days before interest starts building up on any purchases, which is great if you're able to pay off the full balance of your card during that period! That said, if you aren't able to pay off your balance in the first 21 days, you'll be charged interest dating back to the day you made each purchase.

For example, if you buy a new TV for $500 on June 1, you won't be charged interest until June 22. If you pay back that $500 on June 20, you're in the clear and won't pay a nickel of interest. However, if you pay back that $500 on June 23, you'll be charged interest dating back to June 1, when you first bought your new TV.

For cash advances on your credit card, you won't get that same grace period. In fact, most credit card companies will actually charge a higher interest rate on those withdrawals. So if rather than buying the TV with your credit card, you withdraw the cash from your card then buy the TV with that cash, you won't have that same 21-day grace period for paying back the $500, and you'll be charged a high interest rate for that money.

The amount of interest you'll pay depends on the interest rate on your card, but that interest is compounded daily, so it's important to pay off as much as you can each month, even if that's only the minimum payment.

Line of credit (LOC)

A line of credit is similar to a credit card, but it's usually provided for a specific purpose, such as renovations or inventory for a small business.

There are two different types of LOCs: secured and unsecured. Secured LOCs are backed by collateral, or a valuable asset that you own, while unsecured LOCs are not backed with collateral. Because of the collateral, secured LOCs typically have a much lower interest rate than an unsecured loan.

Mortgages

Barring a very fortunate situation, nearly every homeowner requires a mortgage when buying a home. There are two different types of mortgages, which directly impact your payment structure: fixed and variable mortgages.

Fixed rate mortgages are, well, fixed. It's a rate that you're locked into for the duration of your mortgage term. A variable rate mortgage varies based on the prime rate, so if the prime rate lowers, so will your mortgage interest rate and monthly payments, but if prime increases, your payments will too.

Typically, variable mortgages have a lower interest rate than a fixed mortgage, but fixed rates offer greater certainty, as you know the exact payment you'll be making for the duration of your mortgage term.

For example, if you have a fixed-rate mortgage at 2.5% with a 5-year term, your rate and payments won't change during that 5-year span. But if you have a variable-rate mortgage that starts at 2%, but a year later the rate increases to 2.5%, then up to 3% the year after that, your payments will jump. Here's how that would look on a $100,000 mortgage with a 25-year amortization:

Year Fixed interest rate Monthly payment
1 2.5% $447.97
2 2.5% $447.97
3 2.5% $447.97
4 2.5% $447.97
5 2.5% $447.97

 

Year Variable interest rate Monthly payment
1 2% $423.45
2 2.5% $447.97
3 3% $473.45
4 3% $473.45
5 3% $473.45


So with just a 1% interest rate increase on a variable rate mortgage, your payments would increase by roughly $50 per month. If that doesn't seem very significant, keep in mind that a $50 increase on that $423.45 is over 10%. But, if interest rates don't change, and you continue paying $423.45, you're paying $24.52 less per month than you would on a fixed-rate mortgage. It's also important to note that the average Canadian home costs over $500,000, so these numbers are for illustrative purposes only.

There are also two different mortgage types, closed and open mortgages. Open mortgages allow you to pay an additional 10-20% of your monthly payment, which is applied directly to the principal of your mortgage, lowering the overall interest you'll pay, as well as shaving months or years off the length of your mortgage. Sweet!

There's no sure way to say whether a fixed-rate or variable-rate mortgage is better, and it's up to you to decide which type is better for you. If you want a consistent payment each month, fixed may suit your financial style, but if you can handle potential fluctuation as you try to pay your mortgage down faster, a variable-rate may be a good option.

While borrowing money to buy a house, get a car, pay for education or to cover unexpected expenses may be like a step backwards, it's all about staying on top of your payments. When properly managed, borrowing money offers the potential to open up new opportunities to live a better, fuller life, and keeping up with (or getting ahead on) your payments will help you take advantage of those opportunities, while paying as little interest as possible.

Need an expert opinion on interest, managing debt, or to create a financial plan? Find an advisor today to help take control of your financial future.

 

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