November is Financial Literacy Month and we want to help you understand the basics of rising interest rates…so read on to learn more!
What are interest rates, anyway?
Interest is what you pay to a lender to use borrowed money; the interest rate is a percentage of the total amount loaned. Basically, it is how much you need to pay to borrow money.
When you borrow money from your financial institution, for example, by getting a student loan, mortgage or line of credit, you are agreeing to pay back the amount borrowed – the principal – plus interest. The interest rate is set by your financial institution and charged as a percentage of the total amount borrowed. This amount is over and above what your borrowed, meaning you must eventually pay back more than you originally got. Your financial institution must provide you with the interest rate you’re agreeing to when you sign-up for a loan.
There are two types of interest rates typically offered by financial institutions: fixed and variable.
A fixed interest rate stays the same for the term of your loan. A variable interest rate may increase or decrease over the term of your loan depending on a number of factors. One of the biggest things that impacts variable rates is something called the prime rate or prime lending rate. The prime rate is the interest rate that banks and lenders across Canada collectively use to determine the interest rates for many types of loans and lines of credit. Prime, in turn, is influenced by the policy interest rate (or “overnight rate”) set by the Bank of Canada (BoC) – these rates are not the same but are connected, so when the BoC increases its overnight rate, lenders typically increase their prime rates. This is because when the BoC raises the overnight rate, it becomes more expensive for banks to borrow money and therefore they raise their respective prime rates to cover the added costs.
So long story short – because the BoC has been increasing its overnight rate throughout 2022 to combat inflation (a whole other topic we won’t cover here) that means that variable interest rates for all kinds of loans, mortgages and credit products have also been going up.
What to do when interest rates go up
When rates go up it becomes harder and harder to pay down debt because more of your monthly payment goes towards interest instead of the principal amount that you originally borrowed. This can also result in longer re-payment timelines, or in the case of variables rates, higher monthly payments than what you originally expected or budgeted for.
Here are some things you can do when interest rates go up:
- cut back on expenses to put more money towards paying down your debt .
- focus on paying down the debt with the highest interest rate first.
- combine (aka consolidate) high interest debts like credit cards into a loan with a lower interest rate.
- make a realistic budget and map out what you can afford based on rates staying high before your apply for a loan or credit product.
- take stock of your purchasing habits and cut back on incidentals to save more for necessities.
- look for new or creative ways to increase your income to help pay down debt, such as a side hustle or taking on extra shifts.
- keep dedicating some of your monthly income to saving for an emergency – even if it’s a small amount – in case you have to deal with unexpected expenses or higher than budgeted payments due to rising interest rates.
Most importantly, don’t be afraid to ask for help if you need it! Talk to your financial advisor as soon as possible if you’re worried about making payments on a loan, line of credit or other product because of rising interest rates – they can help you find a solution!
This post is adapted from informational content provided by the Financial Consumer Agency of Canada. Read the full article here.