Understanding Interest

04 November 2021 by National Bank

Interest is like a rent payment on a loan—it’s an amount that must be paid regularly until the loan is repaid in full, a bit like the rent you pay for the time you live in rented accommodation.

How are interest rates determined?

Interest rates are calculated as a percentage of the loan amount. The interest rate is set according to the type of loan, as well as many other factors including:

• The rate set by the Bank of Canada, which is the rate that financial institutions pay to borrow money. The lower that rate is, the better the terms that banks can offer you, providing you have a good credit rating.
• Your credit rating, as obtained from your credit file. If you have a good record and a high credit rating, you’ll be able to obtain a lower interest rate. Effectively managing your credit can also help your credit rating, which in turn influences the interest rate when you borrow money.

Varying interest rates

Depending on the type of credit you use, the interest rate can vary significantly. For example, the interest rate on a line of credit is lower than on a personal loan.

Calculating interest

Interest payable on a loan, a line of credit or a credit card is calculated according to pre-set rules.

Interest amounts are usually added to the balance owing at the end of each month.

How interest rates can work for you

If you borrow money, you must pay interest. But, if you invest money in a certificate of deposit, for example, you’ll receive interest. In this case, the investor is the lender and the interest paid compensates for the fact that the investor can’t access the money while the borrower uses it.

The power of compound interest is what allows investors to grow their savings. If you reinvest the interest you earn, this will also generate interest, which makes your savings grow over time.

- Are you wondering what compound interest is?

(rhythmic music)

I'll explain it in less time than it takes me to blow up a flamingo floatie, before I go swimming.

(camera clicking)

(bell dings)

When you invest in an RRSP or a TFSA for example - it can generate interest that gets added to your total.

(blowing)

...inflated.

(cymbal tints)

As soon as you invest your money for more than a year, you earn interest on top of your interest.

Interesting, eh?

This is what's called compound interest.

It's calculated based on your initial investment amount but also on the amount of interest from the start.

Hold on to your hats, we're going to do some math. Are you ready?

Let's say you invested \$ 100 at an annual interest rate of 3 %.

The first year, you'd make \$ 3.

The second year, the 3 % interest is applied to your \$ 100 from the start, but also to the \$ 3 you made, so \$ 103.

Plus, your \$ 3.09 earned in the second year... \$ 106.09

And so on!

Every year your initial investment pays more and more.

So, the earlier you start saving, even small amounts, the more your compound interest will improve over time.

You can even set up regular automatic transfers, that'll really add up.

That is what we call systematic savings.

Check in with your bank to find out more.

(air whistling)

(hissing)

- And now, it's time to go swimming!

- Yeah! Grab your flamingo and hop on the bus.

(engine revving)

(honking)

- The bus?!

Wait!

(bell dings)

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