Photo By: Mike9Alive

“Interest rate” is one of those terms I think I understand, but I don’t fully ‘get’ how it works. Pete is back today with some great answers to my questions about interest rates. He explains what an interest rate is, where we find them, how they’re determined and why credit cards have different rates.

Very briefly, please explain what an interest rate is.

An interest rate is the rate at which borrowed money has to be repaid. It is typically expressed as a percentage. A rate of 1% implies that if you borrow $100, you have to eventually pay $101 back the person or institution you borrowed the money from.

Where do we find interest rates?

Interest rates are involved in a countless number of financial transactions — any time any amount of cash is borrowed or saved, really, although they’re often surreptitious enough that you don’t really see them. Some obvious examples are things like mortgages and credit cards. If you apply for a mortgage, the bank will agree to lend you a fixed dollar amount, say, $200,000. In exchange, you promise to pay them back their original money, plus whatever the interest rate they offer, within a fixed amount of time. With credit cards, credit card companies are essentially “loaning” you money to pay for a transaction, with the understanding that you will be charged interest on what you buy, after a certain date.

Interest rates also come into play when you’re saving money, not borrowing. A standard savings account at a bank will have a posted interest rate. A savings account with an interest rate of 5% would mean for every $100 you deposit into the bank, the bank will give you $5, on top of your original investment.

What’s a typical interest rate for a savings account vs. a chequing account?

The Toronto Star has a handy chart.

Typically, a chequing account pays next to no interest, not much more than 0.1%. The reason for this is that money doesn’t tend to stick around in chequing accounts, so banks won’t give you much interest on it because they can’t depend on it being there. Whereas a savings account is typically more long-term, so they give you a bit of a reward for your patience.

As far as savings accounts go, the rates have come down lately. The best I can find is ICICI Bank (an online bank base in India, operating in Canada) at 3.4%. But the average is probably around 2.5-3.25% right now. Not that long ago, they were near 5, for example, but as the Bank of Canada slashed rates, the trickle-down effect brought down the rates on savings accounts.

How are interest rates determined?

Rates are determined at the discretion of the lender. Basically, within certain legal limits, banks are entitled to loan you money at as high a rate as they want. The higher the rate, the more money they theoretically make off of you. But there are caps on it, as if they post their rates much higher than other banks rates, they’re unlikely to bring in any new business.

Mortgage rates are loosely based on the Bank of Canada’s interest rate, although it’s not 100% linked. Maybe you’ve heard something like, “The Bank of Canada dropped interest rates by a quarter of a point today.” That means is that the Bank of Canada has cut something called the “overnight lending rate” — the rate that banks charge each other to borrow money for short-term loans to each other.

Typically, mortgage rates are very closely connected to whatever that rate is — although as I said, it’s not 100% directly related to it. A bank can charge you any rate you’ll agree to, but the lower the rate they’re offered by the Bank of Canada, the more likely they’ll be agreeable to pass those savings on to you, and vice versa. A bank that was borrowing money at 5% and loaning it out at 4% wouldn’t stay in business for very long.

In an indirect way, then, the central bank’s of different countries “set” the basic rate upon which all other rates are based in that country. They try to balance a number of factors in making their rate decisions, but in a very basic way, the Bank of Canada cuts rates when it’s trying to stimulate the economy. The lower rates are, the more likely you are to borrow money for things like expanding a business, and buying a home — all of which are good for the economy. When they raise that rate, that’s the Bank of Canada’s way of trying to slow down the economy. Reasons for this may be because the economy is getting ahead of itself, inflation is too high and things might be headed for a crash.

Why do some credit cards charge higher interest rates than others?

The short answer is, because they can. The goal of any credit card is to keep you constantly paying off the minimum — not a penny more, and not a penny less, every month. It’s a bit of a delicate art for them to try to guess exactly what rate they can afford to charge you without you going bankrupt, which is bad for them because then you don’t pay them. It’s also bad for them if you can easily pay your bill, because then you’re not paying them on an ongoing basis.

Let’s say there are two credit cards. One charges 15%, and one charges 30%. You, obviously, are better off with the 15% card. A bank might offer the 15% card to someone who has an excellent history of paying back money they borrow (known as a “credit history”). They’re willing to give you a rate as low as 15% because you’ve proven yourself to be a low-risk of defaulting on that loan.

Or, you might be paying an annual fee for your card, in which case you get a lower rate because the bank already gets that $100 fee from you every year. In that case, it’s less urgent for them to gouge you on
the interest rate from month-to-month.

The 30% card, on the other hand, would be offered to people who have bad credit history. You can get bad credit history, if you have a history of doing things like not paying your phone bill, for example. In this case, it makes sense that a bank might look at you and think “this person might not pay us back, either” so they charge you a higher rate to make up for the higher risk they are taking by loaning you money.

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Thanks Pete. If you have any other questions about interest rates, please ask them in the comments and I’m sure Pete would be happy to answer them. Have a financial term you’d like explained? Leave a comment or suggest it in an e-mail: and.chiu [at] gmail dot com.

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