Fixed versus Variable Interest Rates
Canadian financial institutions usually use two methods to calculate “interest rates”. The methods are almost identical for both borrowed money and saved money. In this article, the term, financial institution, refers to banks, credit unions, and other companies that you may receive or pay interest to them. I have excluded Pawnbrokers and instant cash money companies from this article as they may treat you differently.
Interest Rates When You Borrow Money
You usually borrow money through:
- credit cards
- credit lines (or lines of credit)
- short-term loans (usually less than a year)
- long-term loans (could be several years)
- mortgages (when you offer your building as a security against the loan you receive)
Interest is the cost of borrowing money from a financial institution. Interest rate is a percentage or ratio that relates the interest to the amount of money that you have borrowed. The amount of money that you have borrowed is called “the principal”.
As soon as you borrow money you need to pay interest on it. Borrowing via credit cards is a bit different. Credit cards usually offer a grace period to their users. If the user pays off his/her debt in full within the grace period then no interest will be calculated on the borrowed money. The grace period is usually less than 60 days.
When you use other methods of financing and borrowing you need to pay the interest and sometimes part of the original borrowed money (the principal) on certain intervals, usually weekly, biweekly, or monthly.
Fixed Interest Rate is relatively easy to calculate. For example if you borrow $100,000 and your interest rate is 12% per year you need to pay $1,000 interest on a monthly basis (i.e. $12,000/12).
Variable Interest Rate is usually tied in with the financial institution’s prime rate. The deviation from the prime rate is usually fixed. For example if the rate is prime+1% and the prime rate sits at 3.25% then your interest rate would be 4.25%. The deviation from prime could be positive or negative depending on your credit score, the amount you borrow, your financial status, and so on.
Banks and other financial institutions define their prime rate based on Bank of Canada overnight rate. Bank of Canada uses overnight rate as one of its tools to manage Canadian economy. If the economy is shrinking it is very likely that the Bank (i.e. the Bank of Canada) reduces overnight rate and so does the variable interest rates drop. If the economy is booming or the inflation rate is high it is very likely that the Bank increases the rate. Therefore, this amount varies from time to time which consequently affects the prime rates of the financial institutions and variable interest rate loans.
It is usually a wise decision to take a variable rate loan in a shrinking economy and a fixed rate loan when the economy is booming or the inflation rate is high. Of course, you need to consider many other factors, such as how flexible you could be if the economy changes direction.
Interest Rates when you Save Money or Invest
Financial institutions usually use similar policies toward interest rates whether you borrow money or deposit money for the purpose of receiving interest. Of course, the interest rate that you receive is usually lower than the interest rate you have to pay (and that’s how banks make money). If you intend to deposit money and receive interest you may consider one of the following options.
- A savings account
- A chequing account (not every chequing account offers interest)
- A Guaranteed Investment Certificate (GIC)
Financial institutions may offer you other methods to receive interest on your deposit.
Other Methods of Investment
If you are looking for alternative methods of investment which could result in more returns – in exchange of taking more risk of course – then you may consider one of the following investment options.
- Purchasing bonds or debentures
- Purchasing stock shares
- Purchasing mutual funds (which are usually a combination of bonds, stock shares, or even GICs, and/or other instruments)
- Getting involved in trading derivatives such as futures, options, or forwards
- Trading commodities such as gold, silver, and so on through spot trading
- Trading currency through the Forex market
- …
The list is endless. You, however, have to make sure to either educate yourself or consult with a professional and licensed financial advisor before taking risky investment routs.
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