Interest is often referred to as “money rent” because it is a sum that must be paid between the time of borrowing and full repayment, as one would pay rent for the duration they live in a dwelling.
Interest rates are calculated as a percentage of loan amounts. The
interest rate is set according to the type of loan requested, as well
as numerous other factors including:
- The rate set by the Bank of Canada, which represents the rate
payable by financial institutions for borrowing money. The lower that
rate is, the better the terms that banks can offer you, providing that
you have good credit;
- Your credit rating, as obtained from your credit file. A better
record and a higher credit score makes it possible to obtain lower
interest rates. Therefore, the better you manage your credit, the
better your overall credit score will be and the less you are likely
to pay in interest when borrowing.
Varying interest rates
Depending on the type of credit you use, the interest rate can vary
significantly. For example, the interest rate applied to a line of
credit is lower than that imposed on a personal loan.
Similarly, interest rates for bank credit cards are typically better
than rates imposed on credit cards issued by a department store.
Interest payable on a loan, a line of credit or a credit card is calculated according to preset rules.
Advertised rates are annual rates, i.e. 19.99% for a credit card. However, the manner in which the amount payable is calculated will have a significant impact on the total amount of interest paid. For instance, if interest is calculated daily, it means that the total amount you owe each day is subject to an interest rate representing 1/365th of the advertised annual rate.
Interest amounts are usually added to the total amount owing at the end of each month. Therefore, any interest that you pay on interest is known as “compound interest”.
For example, if you have a $10 balance and you add $1 in interest at the end of the month, you will pay interest on $11 next month.
If you borrow money, you must pay interest. But, if you invest money in a certificate of deposit, for example, you are the one who will receive interest. In the latter case, the investor is the lender and interest paid compensates for the fact that the investor can’t access the money while the borrower uses it.
It is therefore the power of compound interest that allows investors to grow their savings. If the interest received is reinvested, it will also generate interest, which will grow savings grow over time.
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