Understanding how interest rates work in Canada
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Understanding how interest rates work in Canada




When moving to a new country, your finances are an important part of setting in. Most newcomers start off with opening a savings and a chequing account at a bank of their choice and then graduate to other investment and credit products.


As you settle in, you’ll have to make various financial choices; some are simple (like choosing a savings account or credit card) while others may be slightly more complex (for instance, deciding between a fixed or a variable interest rate for a mortgage). One of the things that impacts your money in a savings account or the loan you need to repay is the interest rate.


Understanding how interest rates work can be confusing – not just for newcomers, but for those who’ve been in the country much longer. Having a strong base in financial literacy can be useful while managing your personal finances and planning for your future.


Who sets the interest rates in Canada?

The Bank of Canada is the nation’s central bank and the key entity that determines the interest rate in Canada. Its principal role is to promote the economic and financial welfare of Canada. The Bank influences the supply of money circulating in the economy, using its monetary policy framework to keep inflation low and stable. It promotes safe, sound and efficient financial systems, within Canada and internationally, and conducts transactions in financial markets in support of these objectives. Additionally, the Bank of Canada also designs, issues and distributes Canada’s bank notes and acts as the “fiscal agent” for the government of Canada, managing its public debt programs and foreign exchange reserves, and setting the policy interest rate.


What is the policy interest rate and why is it important?

The policy interest rate is also known as the overnight rate. It is the interest rate at which major financial institutions borrow and lend one-day (or “overnight”) funds among themselves so they can cover the daily transactions of their customers (including individuals, businesses, and investment funds); the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank’s policy interest rate.


Policy interest rate in action

Generally, when the policy interest rate declines, it makes debt less expensive (you can borrow more at less interest) and savings less lucrative (you earn less interest on your savings and investments). For example: If you’re looking to buy property it’s advantageous to do so while the rate is low because you’ll be better positioned for a mortgage stress test.


With a lower policy interest rate, your savings, on the other hand, will take a hit. Money saved in a High-Interest Savings Account (HISA) or locked in an investment product like a Guaranteed Investment Certificate (GIC) will earn less interest.


What are the types of interest rates?

There are a few different types of interest rates you may come across in Canada. Here are the most common ones:


Prime rate or prime lending rate: It is the annual interest rate on which major Canadian financial institutions base their individual lending rates for variable loans or lines of credit. The interest rate offered to you could be above, below or at prime lending rate.


Most loan or credit products offer two types of interest rates to borrowers: fixed or variable. Depending on your financial needs and situation, one may be more beneficial than the other.


Fixed rate: Refers to an interest rate that will not change during the entire duration of your loan repayment or in the case of a mortgage, the length of your loan term. Fixed interest rates are beneficial in anticipating payments and making sure you have enough money to repay the amount owed.


Variable rate: Refers to an interest rate that can change on a monthly basis. The variable rate is influenced by the market premium and/or the bank’s prime rate; it can either be positive for you (a lower interest rate) or negative (a higher interest rate). When you borrow money at a variable rate, your risk premium will be given to you in the same way as in the fixed-rate, based on your credit history.


Annual percentage rate (APR): An APR is the percentage of interest to be paid on your loan over a year. It can be calculated on daily, monthly, or (more commonly) on an annual basis. In Canada, lenders are legally required to show the APR on the loan agreement – this makes it easier for borrowers to compare interest rates from different lenders.


The legal limit for APR in Canada is 60 per cent, including fees and charges – meaning, the maximum interest you can be charged on a loan is 60 per cent. The exception to this is payday loans. A payday loan is a type of last resort loan in which you must repay the borrowed amount by your next payday (generally, a two week period). Payday lenders charge high-interest rates and fees in order to make short-term profit.


How credit scores affect interest interest rates

Having a credit rating or a credit score is essential for life in Canada. A credit score is a way for financial institutions to measure your ability to repay loans.


In Canada, your credit score and credit history can influence the interest rate you receive on loans, mortgages, or other credit products. The lower your score, the less likely you are to be approved for a credit card, mortgage, or loan. And if you do qualify for one, it’s likely that the interest rate you receive will be high – which is not beneficial. Conversely, the higher your credit score, the more likely you are to be approved for a credit card, mortgage, or loan and receive attractive (low) interest rates.


As you settle in Canada, interest rates will invariably affect different aspects of your financial life. Understanding how interest rates work will help you make better financial choices, manage your debt, and make favourable decisions with your savings products. And when in doubt, always consult a financial advisor – they can guide you based on your unique financial situation and advise on which options make sense for you.


Original article located here, published by Arrive.


About Arrive

Arrive is powered by RBC Ventures Inc, a subsidiary of Royal Bank of Canada. In collaboration with RBC, Arrive is dedicated to helping newcomers achieve their life, career, and financial goals in Canada. An important part of establishing your financial life in Canada is finding the right partner to invest in your financial success. RBC is the largest bank in Canada* and here to be your partner in all of your financial needs.


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