By Carla Hindman
Director of Financial Education, Visa Canada
One of the most valuable financial lessons you can share with your kids before they leave the nest is to explain what interest rates are and how they work. The important financial transactions they’ll conduct as adults will likely be affected in some way by interest rates, whether as a lender or a borrower.
Here’s some background information to help guide those conversations:
Interest rates for lenders. Anyone who has a savings account or owns government or business bonds is, in effect, lending money to those institutions and earning interest on the loan. In most cases, however, this interest income is probably taxable, so shop around for favourable rates to maximize your earnings and help offset inflation. Compare bank GIC, savings and chequing account interest rates online to see where the best offer is.
Interest rates for borrowers. Interest rates have even more impact on you as a borrower, especially for large purchases. For example: while mortgages have a set term, most are amortized over 15 to 25 years, so reducing the interest rate by a point or two could save tens or hundreds of thousands of dollars over the life of the loan. And credit card rates may vary by 10 points or more, depending on your credit rating.
Most borrower interest rates are expressed in terms of annual percentage rate (APR). With credit cards, the issuer may charge a fixed APR, or change it as bank interest rates vary (“variable rate”). Each billing period, the company charges a fraction of the annual rate, called the “periodic rate,” on outstanding balances. With mortgages, the APR also factors in origination fees, mortgage insurance premiums and other fees.
Interest rates may also depend on:
- Whether the loan is “secured” (secured by collateral such as a house or car) or “unsecured” (not tied to collateral – like credit cards – so the lender relies on your promise to pay it back). Because they’re riskier for the lender, unsecured loans typically have higher interest rates.
- Credit score – people with higher credit scores are deemed less risky and therefore get much more favourable rates.
- Term length – long-term loan rates are usually higher than short-term rates, because the longer the loan, the greater the risk to the lender that you might default.
Fixed vs. variable. Home mortgage interest rates are either fixed at a set interest rate, or are variable, which means the rate can fluctuate for part or all of the loan period. When rate indexes are relatively high, many opt for a variable rate mortgage, which typically has a lower beginning rate and is therefore more affordable initially. However, when rates climb due to inflation or other factors, variable rate payments can rise sharply, which is why many people prefer the more dependable fixed rate.
Bottom line: Many factors in setting interest rates are beyond our individual control; however, controlling their own credit score – which can have a tremendous impact on interest rates – is an important lesson to learn.
Carla Hindman directs Visa’s financial education programs in Canada. To follow Carla Hindman on Twitter: www.twitter.com/MoneySkillsCA.