Understanding how interest works can help you avoid paying more than you want to for the things you buy, and it can also help you grow your wealth faster.
Interest is the fee you pay to borrow money, or a fee you receive when someone borrows money from you. This fee is generally a percentage of the amount borrowed (the “principal amount”), and that percentage is charged regularly until the money is paid back.
When you borrow money by carrying a balance on a credit card, or taking out a loan or a mortgage, you pay interest. When you deposit money in a savings accounts, term deposit, or GIC (Guaranteed Investment Certificate), you earn interest, because you’re the one lending your money to the financial institution.
Simple and Compound interest
Simple interest is when the person lending the money charges an interest rate only on the principle amount. Any interest earnings or charges accumulated to date are not factored into calculating the interest for the next period.
In some cases, you’ll earn—or pay—compound interest. Compound interest periodically adds the interest amount to the original amount borrowed, so that your earnings—or your debt—will grow faster.
For example: If you take out a loan of $5,000 with an annual interest rate of 10%, you will pay the following amounts of interest over a two year period:
Simple interest:
Year 1: $5,000 x 1 year x 10% = $500 in interest charges
Year 2: $5,000 x 1 year x 10% = $500 in interest charges
Total interest: $1000
Principle plus interest to be paid back after 2 years: $6,000
Compound interest:
Year 1: $5,000 x 1 year x 10% = $500 in interest charges
Year 2: $5,500 x 1 year x 10% = $550 in interest charges
Total interest: $1050
Principle plus interest to be paid back after 2 years: $6,050
Remember that this is a simplified example. Most banks will charge compound interest on a monthly basis, which means that they add interest on top of interest 12 times per year. This means that the loan above could actually cost you $1,101.95 in interest, and total $6101.95 after two years: that’s an extra $50!
Variable interest
While a fixed interest rate remains the same, a variable interest rate changes over time. Most variable interest rates are based on the prime interest rate (the rate collectively set by the banks), which changes periodically. If you are paying or earning a variable rate of interest, those payments or earnings will fluctuate according to the changes in the prime interest rate.
For example: If the prime rate is 1.5% and you’re paying a rate of “prime plus 1” on your mortgage, you’ll pay a total interest rate of 2.5%. If the prime rate rises to 1.8% the following month, you’ll pay interest of 2.8%. If it falls to 1.3% a few months later, your mortgage payments will be adjusted to reflect an interest rate of 2.3%.
Paying interest
Here are some of the most common reasons for paying interest:
Credit cards. When you pay for a purchase with a credit card, you borrow money from the card issuer instead of paying cash. If you repay the money within the interest-free grace period (usually 21 days from your last statement period), you won’t pay interest. But if you choose to make the minimum payment instead, you must start paying interest on the full amount you’ve borrowed.
Loans and mortgages. When you get a loan or a mortgage, you borrow money from a financial institution. Usually, loans and mortgages charge you a lower rate of interest than a credit card, especially if they are secured against property you own. This is because secured loans reduce the lender’s risk: if you don’t repay the borrowed funds, they can take your property as part of the repayment.
Earning interest
Here are some of the most common ways to earn interest:
Savings accounts. There are many different kinds of savings accounts, and they offer a better interest rate than chequing accounts. If your goal is to save and grow your money, consider a high interest savings account. You’ll pay higher fees if you need to withdraw money, but if you just want to save, you’ll earn more interest and reach your savings goal sooner.
Term deposits or GICs. If you have money that you don’t need right now, you can put it to work for you and earn a higher interest rate by placing it in a term deposit or GIC. Your interest rate will be guaranteed for the length of the term, whether it’s one year, two, or three.
Helpful links
- See the various interest rates offered to Vancity members.
- Watch a short video about how credit-card interest works.
