How Do Interest Rates Work?

Credit is the financial tool you use to buy products and services today and pay for them at a future date. Credit solutions include credit cards, lines of credit, personal loans and mortgages. Service providers like cable, telephone, hydro and gas companies also offer credit by requesting payment — usually once a month - for their services after you've already used them.

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When it comes to loans, most lenders will charge interest in return for granting you credit. Similarly, credit card companies and service providers may charge interest if you don't pay off your balance in full or are late in making payments.

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When you borrow money the cost of your loan or line of credit is determined by the interest rate the lender offers, and how long you take to repay the loan. Even a small difference in your interest rate can have a big impact on the amount you will eventually pay. Here are two elements that will affect the interest rate on your loan:

1. General level of interest rates in the economy

   These are influenced by the Bank of Canada, levels of inflation, demand for borrowing money, and a number of other factors.

2. The specifics of your loan or line of credit

   • How much you borrow
   • What kind of loan you get, and whether you put up collateral or not. For instance, the interest rate on a home equity line of credit (where you use your home as collateral) are generally lower than for unsecured credit.
   • The term of the loan — how long you take to pay the money back
   • Your credit rating — generally borrowers with good credit get better rates than borrowers with poor credit.

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Each bank sets its own Prime Rate, but this is usually based on the bank rate set by the Bank of Canada.

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If you have a good credit rating history, you may be able to qualify for a lower interest rate. Also, if you have a number of different accounts with a lender, you may be granted a lower interest rate in recognition of your relationship with them.

Your reason for borrowing could affect your rate. For example, if you're borrowing to invest in your RRSP, your interest rate could be as low as Prime, even on a personal loan.

One of the most effective ways to lower your interest rate is with a secured loan. This is usually done by borrowing against the equity in your home or by pledging investments — such as GICs, Government Bonds, stocks or cash — as security. RRSPs cannot be pledged as security.

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