How is Interest Calculated in Canada?

Interest rates remain a big topic in the news after the Bank of Canada finally lowered its policy interest rate after it remained at 5% for almost a full year.

The Bank of Canada’s policy interest rate affects the prime rate set by other banks, which then determines the interest rates you get on things like variable-rate mortgages, loans, savings, and investments.

Interest works both ways—you earn interest on savings and investments, and you pay interest on debts. But how are interest rates decided, and how is interest calculated on savings and loans? Keep reading to find out.

What is interest?

First, let’s start by explaining what exactly interest is.

The thing is, financial institutions don’t lend out money for free – they’re businesses, after all. For things like mortgages, credit cards, student loans, personal loans, or home equity lines of credit (HELOCs), interest is the extra amount you pay on top of the money you borrow.

As for savings, interest is the money a bank pays you to keep your money with them, whether it’s in a savings account, tax-free savings account (TFSA), registered retirement savings plan (RRSP), guaranteed investment certificate (GIC), or bond. Interest rates are shown as a percentage of the loan or deposit amount.

Interest rates can be fixed or variable, depending on the product. Credit cards usually have fixed rates, meaning you either pay off your balance in full every month or pay a set interest rate on your balance.

Other types of loans, like a line of credit, usually have variable rates. Personal loans and mortgages can have either fixed or variable rates.

While the Bank of Canada’s policy interest rate influences the financial world, individual banks and other financial institutions set their own interest rates for the products and services they offer.

How do you calculate interest?

How interest is calculated depends on the specific financial product and whether simple, compound, or amortizing interest is used.

Simple interest

Let’s start with simple interest. Simple interest is the interest earned only on the original deposit. It does not include any interest earned over time.

Simple interest is easy to understand because it’s calculated once a year based on the original amount (principal). It usually applies to short-term loans and investments.

For loans, this means that as you make payments and the balance gets smaller, interest is only calculated on what you still owe. For savings and investments, interest is only calculated on the original amount you deposited.

Here’s the simple interest formula: P x R x T

• P = Principal amount (the beginning balance)

• R = Interest rate (expressed as a decimal)

• T = Number of time periods (generally one-year time periods)

For example, let’s say you deposit $1,000 into a short-term investment with a 10% annual interest rate and a one-year term. Using the above formula:

• Principal amount = 10,000

• Interest rate = 0.10

• Time period = 10

10,000 x 0.10 x 10 = $10,000. This means that when you deposit $10,000, you will earn $10,000 in interest after 10 years for a total of $20,000.

Because financial institutions only calculate simple interest on the principal, it doesn’t earn or cost as much as compound interest, which includes interest on the interest earned over time.

Compound interest

Unlike simple interest, compound interest grows over time because you earn interest on the interest already added. It’s often called “interest on interest.”

For example, if you have a savings account that earns interest monthly or yearly, the interest will keep earning more interest over time. The rate of compounded interest earned in a year is called the annual percentage yield (APY).

Compound interest is usually used for things like savings accounts, investments, and credit cards. It helps grow your savings faster than simple interest because the “interest on interest” effect increases the total amount more quickly.

Here’s the compound interest formula: A = P(1 + r/n)nt

• A = Accrued interest (principal + interest)

• P = Principal (the beginning balance)

• r = Annual interest rate (expressed as a decimal)

• n = Number of compounding periods per unit of time (daily, weekly, monthly, etc.)

• t = Time in years (expressed as a decimal)

Using a similar loan to our simple interest calculation, here’s how compound interest would work if you deposit $10,000 into an investment with a 10% annual interest rate and a 10-year term, with interest compounding monthly.

• P = 10,000

• r = 0.10

• n = 12

• t = 10

Using these numbers, we can figure out how much compound interest you would accrue in a year:

• A = P(1 + r/n)nt

• A = 10,000(1 + 0.1/12)(12)(10)

• A = 10,000(1 + 0.0083333333333333)(120)

• A = $2,707.04

After 10 years, you would earn $7,070.41 in interest on top of your initial $10,000 balance, for a total of $27,070.41.

When comparing the two examples, over 10 years, you will have earned over $7,000 more with compound interest than you would with just simple interest.

Amortizing interest

As you can see, calculating simple interest or compounding interest is pretty straightforward for fixed-interest rate debt or savings accounts over a set period.

However, other types of debt, like mortgages, can have terms and amortization periods that change the interest amount you pay. For example, a mortgage might have a 25-year amortization split into shorter terms.

If you have a 5-year fixed-rate mortgage, when it’s time to renew after five years, the interest rates could be higher or lower, changing your interest payments.

The main difference between amortizing loans and simple interest loans is that amortizing loans have interest-heavy payments at the beginning.

This means that, at first, more of your monthly payment goes toward interest rather than the principal loan amount. Then, as time goes on and you get closer to paying off your loan, this changes.

Toward the end of your loan, most of your monthly payment goes toward the principal balance, with less going to interest.

There is no specific formula for amortizing interest. Instead, three things are considered for the calculation:

• The amount borrowed

• The loan duration

• The annual interest rate

Now, here’s how that would look. Let’s say you are approved for a mortgage, and you borrow $550,000 at 5% for 25 years at a fixed monthly payment of $3,198.83.

First, we’ll need to divide your interest rate by the number of payments you’ll make that year:

• 0.05 ÷ 12 = 0.0042%.

Next, you’ll need to multiply it by the remaining loan balance:

• $550,000 x 0.0042% = $2,310

Finally, you need to subtract the interest from your fixed monthly payment:

• 3,198.83 - 2,310 = $888.83

This means that for the first month, you’re paying $2,310 in interest and only $888.83 in capital.

You’ll have to repeat this process every month to calculate your amortizing interest, and you’ll need to subtract the repaid principal from the remaining balance each time.

Who controls interest rates in Canada?

We mentioned the Bank of Canada’s policy interest rate earlier, and if it sounded important to you, that’s because it is. It’s one of the key tools the Canadian government uses to manage the economy.

The policy interest rate, also known as the “overnight rate,” is the rate Canada’s major banks charge each other for overnight loans.

It's a bit complex to explain, but basically, it is the rate at which Canada’s major banks charge each other for overnight loans.

Banks loan each other money to ensure they have enough funds for the next day’s transactions. They charge each other a standardized interest rate, called the policy interest rate, for these loans.

When the overnight rate goes up, it costs banks more to borrow money. To cover these higher costs, banks raise their prime rates and charge clients more interest.

Then, if the overnight rate goes down, banks often follow by lowering their prime rates.

In Canada, the Bank of Canada controls the "overnight" policy interest rate.

The Bank of Canada might raise or lower the policy rate for various reasons, usually related to the economy and inflation.

If the economy is slow or struggling, the Bank of Canada might lower the policy rate to encourage spending.

If the economy is growing too fast and inflation is high, the Bank of Canada might raise the policy rate to encourage saving and reduce spending.

Fixed interest rate vs. variable interest rate

A fixed interest rate means your interest rate stays the same for the entire term of the loan, savings, or investment product. Even though fixed rates are linked to the bank’s prime rate, your rate is locked in during the agreement.

Fixed rates are great for borrowers who want to know the total cost of their loan and make regular payments.

They’re also good for savers who don’t like taking risks and want to know exactly how much they’ll earn from their investments.

On the other hand, a variable rate is an interest rate that changes with the bank’s prime rate.

Variable rates are good for borrowers who want to save money when rates are low and are okay with the risk of rates going up.

They’re also good for investors who want to earn more when rates are high and don’t mind some losses when the market isn’t doing well.

What factors affect how much interest you pay?

When borrowing money, financial institutions charge you interest. This is because financial institutions are a business, and it’s the goal of any business to make a profit.

Your credit score

Your credit score is a major factor in deciding your loan’s interest rate. If you have less-than-perfect credit, you’ll usually get a higher interest rate because lenders see you as a bigger risk compared to someone with excellent credit.

Loan amount and term

The amount you borrow (your principal) significantly affects how much interest you pay. The more you borrow, the more interest you’ll pay because it’s a bigger risk for the lender.

As for the term, shorter loan terms mean higher monthly payments, but you’ll pay less interest overall because you’re repaying it faster.

Longer loan terms may lower your monthly payments, but since you’re borrowing the money for a longer period, you’ll end up paying more interest over time.

Repayment amount

Most loans have monthly payments, but some might be weekly or biweekly. Paying more often than once a month can save you money because frequent payments reduce the principal amount faster.

With compounding interest, making extra payments can save you quite a bit as long as the extra payments go towards reducing the principal.

Earn more interest with a high-interest savings account

Putting your money in an interest-earning account can help grow your savings, but some accounts offer higher interest rates than others. That’s why, to earn more interest, you should put your money in an account with a high interest rate.

Many online financial institutions offer savings accounts with better-than-average rates.

Canadian high-interest savings accounts (HISAs) work like regular savings accounts but offer better interest rates. They can provide some of the best rates, sometimes ten times higher than traditional savings accounts.

For instance, instead of earning less than 1% interest on a regular savings account, a HISA might offer up to 5.0% or more. So, if you have $10,000 in savings, you could earn $500 in interest in your first year.

For example, with a KOHO high-interest savings account, you can earn up to 5.0% interest and up to 5.0% cashback, depending on the subscription plan you choose.

Plus, there are no hidden withdrawal, e-transfer, or NSF fees, and no minimum balance requirement, so you can focus on growing your savings faster.

Just pick a plan, opt-in to earn interest, and start earning right away with your KOHO account.

The bottom line

Understanding how interest is calculated is crucial because it affects both borrowing costs and savings returns. Interest can help you build wealth but can also make debt repayment harder if you’re only making minimum payments and interest keeps adding up.

Always know the interest rate and how it’s calculated when you open a savings account or take out a loan to understand how much interest you’ll be paying or earning.