Helping to make sense of how interest rates are determined.
There are 3 main things that affect how much interest you’ll pay on your loan.
This one’s entirely in your control, but it’s something you need to work at long term. If you have a rock solid credit rating your interest rate’s going to be lower than if you fit the profile for borrowers who’ve left their loans unpaid. Lending money comes with risk – the better bet you are as a borrower, the less interest you’ll pay.
Security or collateral
When a loan’s secured it has something physical backing it up that the lender can use to offset the risk in the case a borrower can’t pay off the loan. This is one reason why interest rates on mortgage loans are low while credit card interest rates are so high. Your home acts as the collateral on your mortgage loan whereas credit cards are unsecured.
The Bank of Canada
This one’s completely out of your hands and it’s also a little bit complicated.
To control inflation, the Bank of Canada can make changes to what’s called the overnight rate. The overnight rate is the interest rate major financial institutions pay when they borrow and lend money to one another for a single day.
When it wants to heat up the economy, the Bank of Canada can lower this rate, making it cheaper for financial institutions – and Canadians in general – to borrow money. People spend more and this causes inflation to increase. When it wants inflation to decrease and the economy to cool off, the Bank of Canada increases the overnight rate and borrowing money gets more expensive. When the overnight rate increases, the interest rate you’d pay on a loan also increases.
In other words, the rate set by the Bank of Canada dictates the rates set by each financial institution. So the economy plays a big role in how high or low rates happen to be on any given day. It’s a good idea to keep tabs on the Bank of Canada rate to know when it’s a good time to borrow.