Understanding Interest

04 November 2021 by National Bank
What Represents Interest?

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. 

Want to know more about this topic? Find out how your credit card works.

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.

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