During a period of major economic change, like the COVID-19 crisis, you see a lot of headlines about changes to interest rates. Feeling like you don’t understand what those changes mean can make things more stressful, so let’s go over some basics: What is interest, how and why interest rates change, and how those changes affect you.
What is an interest rate?
Think of an interest rate as the cost of getting money to use now, in exchange for a promise to pay it back later. When you borrow money from a bank, you pay interest on it in addition to repaying the money you borrowed. When you deposit money in an interest-bearing account (like savings or an investment), you earn interest on it because you are essentially lending money to a bank.
Interest rates can be impacted by a number of things, including the Bank of Canada rate, government programs, economic conditions, and the market. As a result, they can go up and down, changing how much interest you’re paying or earning.
Paying interest
When you borrow money, the interest you pay is a percentage of the total amount you have borrowed (also known as the principal). Each month, the interest percentage is applied to the amount you still owe. So the faster you pay off the amount you have borrowed, the less you will pay in interest. If you build up debt, you end up paying more in interest.
To determine your interest rate, a borrower will also assess the risk involved; in other words, your ability to pay back the money. Generally, interest is higher for people with a low credit score or spotty credit history.
Earning interest
When you deposit money in an interest-bearing account, you earn interest in the form of a percentage of your account balance. The higher your interest rate, the more your savings grow.
How and why do interest rates change?
When you hear about a change to all interest rates, it’s likely that the Bank of Canada has changed its rate. The Bank of Canada rate (also known as the overnight rate) is the rate at which banks can lend funds to each other at the end of the day. Changing this rate has a domino affect on the rates offered by all financial institutions, which allows the Bank of Canada to influence the economy. For example, if inflation is getting too high, the Bank of Canada can raise its interest rate to encourage people to save money, rather than borrow or spend it.
The Bank of Canada lowers its rate when the economy needs a boost. For example, during the COVID-19 crisis spending suddenly dropped - in part because everyone started staying home, but also because many people are losing their jobs and simply don’t have any money to spend. As a result, the Bank of Canada lowered interest rates to help ease the burden on people who don’t have income and keep the economy moving by encouraging businesses to borrow and spend money.
How changing interest rates affect you
There’s a lot of talk about rate changes when the economy is in flux, and it can lead to uncertainty and stress about how those changes affect your money and assets. As we’ve talked about, due to COVID-19 the Bank of Canada has lowered interest rates to help people make payments (like credit cards and mortgages) and encourage people and businesses to borrow and spend money. Ideally, this helps make it easier for the economy to recover. But this is the big picture. What do the rate changes mean for you, specifically?
If you have a mortgage…
When the Bank of Canada lowers its rate, mortgage rates usually go down. You may have noticed that this isn’t the case in Canada right now; in fact, some mortgage rates are going up. This is not because banks are trying to make a bigger profit off you during this difficult time. It’s about balance. Right now, it makes sense for banks to take fewer risks when it comes to mortgages because they have a lot less money coming in. Even for motusbank, where profit benefits members instead of shareholders, the biggest goal is to make sure we’re in a position to help keep the economy as stable as possible and make sure we can help members recover when the crisis passes.
It’s important to remember that if you already have a fixed-rate mortgage, that rate won’t change.
If you have a savings account…
As a result of lower interest rates you will earn less on the balance you have in your savings account than you usually do. Even with a lower rate, though, something like a savings account or GIC is still a secure way to set aside money and earn a bit of interest.
If you have money invested…
COVID-19 has led to big disruptions in the global markets and as a result, you have probably seen a dip in your investments. This is partly because the market is not performing well, but you may also have seen a lower interest rate on your investment account.
The important thing right now is to remember that the market always has ups and downs - so unless your goals have changed significantly it doesn’t make sense to change your overall strategy. Talk to us if you have questions about changing your investments.
How to get rate updates and advice
With Rate Scoop you can get advance notice about upcoming rate changes from motusbank. All you need to do is make sure that your email is up-to-date in online banking.
If you have any questions about how interest rates are affecting your finances, get in touch by calling 1-833-696-6887 or emailing memberservice@motusbank.ca.