Interest rates and investing

Interest rates have been in the news again lately as the Bank of Canada recently announced it will continue to hold rates steady, but may cut rates later this year. Nova Scotians have been in a high interest rate environment for a few years now. If interest rates do begin to decline, what does that mean for investors? Here is a basic rundown on interest rates and how falling or rising rates can affect your finances.

What are interest rates? They represent the amount borrowers pay lenders for borrowed money, and are typically expressed as an annual percentage of a loan’s principal. Rates can often vary depending on the length of the loan, who’s borrowing and who’s lending. You’ll find interest rates in several areas of your financial life, including credit cards, mortgages, student loans, and lines of credit.

There are two interest rates that people pay the most attention to. They are:

Policy Rate: When it is announced that interest rates are rising or falling it is referring to the policy rate. This is also known as the overnight lending rate. In Canada this rate is set by the Bank of Canada.

Prime Rate: This is rate that banks refer to when charging their customer to borrow funds through things like a line of credit.

For investments that receive interest, the investor is the lender. When you purchase debt securities such as bonds or GICs, you are lending your money to a financial institution, company, or government which agrees to pay you back with interest for the ability to use your funds.

Now let’s look at types of interest rates. There are several different types of interest rates, and each loan agreement may have its own specific terms and conditions. Here are the most common.

Simple and Compound: Under simple interest the borrower pays the lender the interest on the loaned principal balance and at set intervals. The interest payments remain the same. Under compound interest the borrower pays interest on the principal as well as interest paid in previous payments. For investments the interest payment increases as time goes on if it is compounded. 

Fixed and Variable: Under a fixed interest rate the rate remains the same throughout the term of the loan. Under a variable interest rate the interest paid can change if the policy interest rate or prime rate increases or decreases.

We’ll finish our brief overview of interest rates with a look at how interest rates affect investors:

Saving accounts: Many savings accounts have a variable interest rate. When interest rates rise or fall the interest paid for these accounts is also affected.

GICs: When interest rates rise the interest paid on GICs also rises and they may be a more attractive investment option for investors. As interest rates fall the rate paid on a GIC also declines. A locked in GIC may look better or worse as an investment when interest rates change.

Bonds: When interest rates decline that means the bonds sold today will pay less interest than bonds you purchased prior to the rate decline. A decline in interest rates essentially increases the price of bonds as you are paying the same amount for less return.