The world economy continues to navigate rising inflation after the 2019 pandemic. In response, the state’s monetary policy adjusts interest rates to control the prices of goods and services by decreasing or increasing rates as needed. Recently the “Bank of Canada reduced the policy rate by 25 basis points to 4.25%”. What does this mean for your finances?”
This post will break down how shifts in interest rates affect your finances and how you can stay ahead of the curve to leverage these changes to your financial advantage.
Understanding interest rates
First, the interest rate is the amount a borrower pays to its financial institution besides the principal owed.
Some Common Interest Rate Terminologies
These interest terminologies vary depending on the financial institution providing the services. For example, simple interest rates are not widely used compared to compound interest by lenders. The policy rate is the chief of all the rates because it determines how other rates are set for the lenders and creditors. You must pay close attention to the monetary policy rate, which in most countries the Central Bank.
- Simple Interest and Compound Interest: Simple interest is when the borrower pays interest on the amount borrowed. For example, suppose you borrow a loan of $100 at the simple interest rate of 2% per annum which comes to $2 interest per year. Simple Interest = $100(Principal) x 2% (interest rate) x 1(year) = $2Compound interest occurs when the borrower pays interest on both the principal amount and the accrued interest, resulting in interest being charged on interest. This causes the annual interest to increase each year. The compounding effect is beneficial for high-interest savings due to the exponential growth of the principal over time.
- Variable Rate vs. Fixed Rate: In a variable rate loan, the interest rate fluctuates based on changes in the central bank’s policy rate. In contrast, a fixed interest rate remains constant throughout the loan term, though it is adjusted according to the current policy rate at the end of the term.
- Policy Rate vs. Prime Rate: The policy rate set by the central bank to manage short-term interest rates and control inflation; it can change often. The prime rate is set by banks and reflects the interest rate they offer to their most creditworthy customers.
- Annual Percentage Rate (APR): APR shows the yearly cost of borrowing, including any associated costs or fees. It is commonly used to express the cost of loans and credit card charges.
How does Interest rate impact your finances?
Understanding the rise and fall of interest rates is crucial for your finances, and it is important to leverage these shifts to your advantage when managing loans, debts, investments, and savings. Below are some of the effects of interest rate fluctuations:
Loans/Debts Amid Interest Rate Shifts
Higher interest rates increase the cost of borrowing from lenders, including loans, lines of credit, credit cards, consumer debts, and mortgage loans. Remember, if you have a fixed-rate loan, you will not see the effects of a recent rate hike right away but after the loan term. Nevertheless, if you have a variable rate, the impact will be reflected in your statements within a few days or weeks.
On the other hand, lower interest rates reduce the cost of borrowing, significantly increasing your chances of securing loans. For example, this is an excellent time to get a mortgage or secure loans for essential projects like home renovations. To manage periods of higher interest rates, consider borrowing less by avoiding discretionary loans when possible, paying off high-interest debt, and reducing spending to reduce costs.
Investments Amid Interest Rate Shifts
Conversely, higher interest rates can help certain investment vehicles like Guaranteed Investment Certificates (GICs), high-interest savings accounts, and bonds and bond funds. Still, they are less favourable for stocks and equity funds. This is because equities represent companies that rely on cash to expand their businesses. When borrowing costs increase, businesses often reduce their expansion plans, resulting in lower earnings available for reinvestment, dividend payments, or stock buybacks. As a result, investor demand for shares decreases, leading to a decline in stock prices. This explains why you notice that when the Bank of Canada announces an interest rate hike, the stock market tends to fall, while rate cuts often lead to a surge in stock prices.
Sources
Bank of Canada. (2024). Bank of Canada reduces policy rate by 25 basis points to 4¼%. Bankofcanada.ca. https://www.bankofcanada.ca/2024/09/fad-press-release-2024-09-04/
Equifax. (n.d.). What Do Interest Rates Really Mean? http://www.equifax.com. equifax.com/personal/education/personal-finance/articles/-/learn/what-do-interest-rates-mean/
Governement of Canada. (2013). Protecting yourself if interest rates rise. Www.canada.ca. https://www.canada.ca/en/financial-consumer-agency/services/interest-rates-rise.html
Kimmel, P. D., Weygandt, J. J., Kieso, D. E., Trenholm, B., Irvine, W., Burnley, C. D., Booth, L., Cleary, W. S., Kohser, R. A., & Aly, I. M. (2020). Financial Management (2nd ed.). John Wiley and Sons Inc.
TD Bank. (2023). Rates are rising: Here are some of the ways that could impact you | TD Canada Trust. Www.td.com. https://www.td.com/ca/en/personal-banking/advice/growing-money/how-interest-rate-hike-in-canada-could-impact-you
TD Bank. (2024). Understanding Interest Rates in Canada – TD Canada Trust. https://www.td.com/ca/en/personal-banking/advice/growing-money/understanding-interest-rates-canada
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