Rounding it up
Interest rates aren’t just about the money you owe lenders for your car or home — they also tell you about the money you can expect to make from investments.
For example, savings vehicles; from simple savings accounts to complex retirement savings, they are all affected by interest rates in one way or another
Understanding how interest rates affect different types of savings and investments can help you plan for your financial future.
We've said it before and we’ll say it again: One of the most important things you can do for you and your family’s future is save. But the journey doesn’t end at opening a savings account and calling it a day — not if interest rates have anything to say about it.
It may not seem like interest rates have a whole heck of a lot to do with your savings account, but they absolutely do. That’s why we’re going to take a look at how savings and interest rates relate to one another and what you need to keep in mind when planning for the future.
So, what is an interest rate?
Put plainly, an interest rate is the percentage that a lender charges a borrower for using money. Let’s say that you borrow $100 at 1% interest and the loan is due tomorrow; you’d pay back $101 — $100 of principal, or the original amount, and $1 of interest, or the fee for using the money.
If you’re earning interest from a bank, the same logic applies, just in the opposite direction. A bank or lender would pay you for “using” your money.
To learn how interest rates affect savings, we have to dig into how they work. Every single financial transaction is built upon what’s called the prime interest rate. This is the interest rate that banks use as a starting place to lend or provide interest payments to consumers. The prime rate is developed by each financial institution alone, but is generally based on the policy interest rate established by the Bank of Canada (BoC). The rate currently sits at 0.25%.
The prime interest rate in both cases is the floor of most loans, plus the additional interest necessary for a bank to make money. So a standard mortgage rate for an extremely well-qualified borrower would likely be around 2.45%, as of this writing (May 2021).
Interest rates that affect your savings are also based on the policy interest rate. So if the rate at which banks can borrow money from the government goes up, they’re more likely to pay you a bit more to rent your money instead. For example, in the 1980s it was common to see double digit interest rates on savings. Why? Because the rate at which the banks can borrow money from the government was in the high single digits, making it cheaper to “borrow” money from you and pay you more interest.
This principle is true for everything that has to do with an interest rate, whether you’re repaying a loan or the bank is paying you. Everything derives from the first rate with the government, and then the policy interest rate.
So what are savings?
Savings can take various forms. Some folks like to keep cash nearby, like in their home or in a safe deposit box. Some like to keep extra capital in an accessible account. Others prefer to “lock” the money up in accounts that will charge a penalty for early withdrawal — a great choice if you have a tendency to overspend.
The most common type of savings, however, are your standard savings accounts. Usually linked to your chequing account at the same financial institution, your savings account is a reliable way to hold onto money while making it work for you. That’s because your savings account is usually interest bearing. Now, the interest isn’t astronomical; the absolute highest in the last several years is just about 1%. However, your money won’t be subject to market fluctuations and will be insured up to a certain point.
"Put plainly, an interest rate is the percentage that a lender charges a borrower for using money."
What about certificates of deposits, stocks, and bonds?
If you’d like to see higher flow into your savings accounts, then consider certificates of deposits (CDs). The average CD offers a rate of about 1.25% in Canada as of this writing. It’s a bit higher than your traditional savings account because you’re required to keep your money exactly where it is for a set period of time. If you withdraw it early, you might face steep fees.
Next up, stocks and bonds. It’s useful to think about them as savings as well. Yes, we often use the term investments, but in reality, these are simply more complex savings accounts that are tied to the market. This connection makes bonds and stocks a bit riskier but also makes the returns much higher. Plus, if your portfolio is diversified and well funded, you can save quite a bit of money for retirement or other purposes.
Bonds are absolutely affected by interest rates. The two share an inverse relationship: when rates go up, bonds become cheaper. This is because bonds pay a fixed rate up through maturity. When interest rates go up, that guaranteed payment that made bonds so attractive is no longer the best deal in town — you can likely get more in return from the higher rate. However, when rates go down, investors and consumers want that guaranteed payout, thus bonds become more expensive.
While stocks and market investments are less affected by interest rates, they’re still impacted. When a large central bank changes the target interest rate, borrowing money can become more or less expensive. Just like you and me, financial institutions have to pay interest on money they borrow, then turn around and loan to you. When there is a change in the interest rates at which they’re borrowing, the interest to other borrowers changes as well. At a company level, higher interest rates can have a negative impact on share prices or drag its earnings down, because it has to expend more capital paying the bills. This can, in turn, affect the value of your investment.
What else should I view as “savings” that are affected by interest rates?
When you’re thinking about your financial health, it’s important to consider everything in your portfolio. If you expand the definition of savings, you can include your home in it as well. The value of your house is drastically affected by the area and the overall market in home sales, but it can also be a valuable savings vehicle impacted by interest rates.
Let’s say you purchase a fixer upper in an up-and-coming area. You spend a few thousand dollars and live in it for a while, until the market demand for the home increases. You’re able to sell your home for quite a bit more than the price at which you purchased it just a few years earlier.
In a way, you’ve just used your home as a savings account. And if interest rates are low, buyers may be more attracted.
What about my grandmother’s gold bullion?
This sounds a bit like a joke, but precious metals and jewelry have tangible value, as long as you’re willing to part with them. They’re also a great way to keep your savings close, if that’s your preference. The price of precious metals and stones, like gold and diamonds, fluctuate just like any other asset. In fact, the price of gold is listed on commodities exchanges around the world.
Stay interested in interest rates
Interest rates affect nearly every part of our lives. From mortgages and car loans to savings accounts and even precious metals, they affect how much we can expect in return and how much we’re expected to pay on top of a loan. When you’re thinking about your overall financial position, consider where interest rates currently stand and the types of savings vehicles you can use to meet your goals.
Maybe you’re focused on short term savings for an upcoming vacation — a savings account might be just right. Perhaps you’re looking far into the future and planning for retirement — stocks and bonds may be a better fit, and they’ll return a better profit. Whatever you choose, interest rates will play a huge role in determining how your savings ultimately perform. Going in with an understanding of your savings goals and a grasp of how interest rates can affect them will give you a great place to start.
Dan is a runner and writer living in the Washington, D.C. area, where he currently works for a financial services trade association as the Communications Director.