Interest rates are pesky, mostly because no one wants to pay them in the first place, but also because they seem to constantly change. You may get your mortgage at a nice, low interest rate only to discover that the morning, rates have dropped. That’s not fair, is it?! Who determines this stuff anyway?
Glad you asked. Interest rates are some of the most important parts of the economy because they are tied to a vast amount of activity. Central banks, like the Bank of Canada, can use the interest rate to stimulate or cool off the economy. And banks and financial institutions can post their interest rates to defray the cost of risk they’re taking. There are different types of interest rates, so let's take a look at them, what they do, how they change, and who’s doing the changing.
What is Interest?
The first step to understanding who determines interest rates if understanding exactly what an interest rate is. Pure and simple, an interest rate is the amount you pay to rent money from a bank or financial institution. The interest rate itself is determined by a variety of factors, including:
The type of financial instrument in question
The term (how many months or years the loan will be repaid)
Your specific credit history and financial situation
The economic condition
Let’s take those in order. Personal loans, for example, have far lower interest rates than credit cards. This is because, generally speaking, they are closed lines of credit. You borrow a certain amount of money for a thing, like furniture or a television, and you repay it over the term of the loan. Credit cards, on the other hand, are revolving lines of credit. You can continually use them and charge more money on them until you reach your credit limit.
Mortgages will have some of the lowest rates of any financial instrument because of that second bullet (above). The term of a mortgage tends to be much longer than any other loan type. The longer the term, the lower the rate. This is because the monthly payments you’re required to submit are much lower, thereby lowering the risk that you’ll default on the loan in the first place.
The third bullet is a very important one and a way that you can control the kind of interest rates you get. Your credit history is made up of your credit report and credit score. Your credit report contains all of the transactions that used your credit over the past seven years. It also shows payment history, how old your credit is, and the amount of credit you’re utilizing at any one time. Equifax and TransUnion are the two companies in Canada that track your report and combine all of these elements to give you a score. You can get your free Equifax report from the Canadian government. Many banks and credit card companies also now offer free access to reports and scores.
The specific lender may take information from your report and score and apply their own methodology to it, thereby producing a score that better meets their business needs.
The final bullet deals with the economic situation. If the prime interest rate set by the Bank of Canada is high, then you can expect the interest rate you get for your home, car, or furniture to be high as well.
You may have noticed that I referenced the prime interest rate above; your bank or financial institution may set their own interest rates for their products, but they’re subject to an interest rate as well, set by the Bank of Canada. The Bank of Canada uses its prime rate to control the economic situation in the country. If it needs to spur economic activity, the Bank will lower its rate and make it cheaper to borrow money.
If they need to rein in the economy a bit, to control inflation for example, they can raise their rate, thereby making it more expensive to borrow and removing money from the economy. (This is what’s currently going on in the economy at time of publication.)
This works because financial institutions have to lend to each other to cover the deposits of their customers each day. The rate at which they borrow money from one another is the Bank of Canada’s rate, which currently stands at 4.25%, the highest it's been for the last several years.
The Bank of Canada has been steadily increasing its rate over the last several months. This has been done in an effort to control ballooning inflation as a result of the COVID-19 pandemic and the economic troubles it caused, as well as other global economic factors. It’s also worth mentioning that demand for goods remains incredibly high, driving prices up. By increasing its rate, the bank can reduce the amount of cash in the economy and force prices down as – on a very basic level – people have less cash to spend.
Doing this has its own unique risks, however; if the Bank slows the economy too much, it can push it into a recession, which means the economy starts shrinking instead of growing.
So Who Actually Determines the Rate?
When you go to a bank or financial institution, they’re determining the rate at which you can borrow money. They’re also determining the rate they’ll pay you for keeping your savings account balance. However, they’re pricing in their own costs when they borrow money using the Bank of Canada’s prime rate. This is akin to a mechanic incorporating the cost of his time for fixing your car as well as the materials he needed to complete the job. He had to order those brake pads for your wheels and you’re going to pay for that along with paying for his expertise when he’s putting them on. The bank, in turn, is going to charge you for the amount they needed to pay to get the money and the amount needed to keep the lights on. So, the bank is the end-all, be-all that determines the rate for your product, but they’re packaging in the rate from the Bank of Canada as well.
How Do I Guarantee I Get a Good Rate?
There are really no guarantees when it comes to interest rates, but there are a few things you can do to maximize your chances of getting a favourable interest rate.
Plan & Budget
Not purchasing on a whim is the best way you can guarantee yourself a great rate. Credit decisions shouldn’t be taken lightly, and ensuring your purchase conforms to your overall plan is crucial. Ensure too that it matches your budget and you have enough breathing room to make the payments for your shiny new loan.
Watch the Market
People need things no matter what the market does. If your car breaks down and you need to purchase a new one, it's impossible to wait for lower rates from banks and financial institutions. Still, if you can hold off on credit purchases while interest rates are high, you should. There may not be a pressing need to buy that new jet ski right now, given that you’ll pay more for it than you would perhaps in a few months.
Watch Your Credit
Your credit report and score are the keys to purchasing things at favourable rates. Economic conditions play a role, but your credit report will be the most important factor. If you’ve missed lots of payments or have a very young credit history, you shouldn’t expect favorable treatment on a new loan.
Increase the Term
If you increase the term of the loan you’re getting, you can often get a lower rate. Keep in mind that you’ll likely end up paying more interest over the life of the loan because you’ll have it for a longer period of time. Additionally, in the case of a car loan or other depreciating asset, you’ll end up owing more than the vehicle is worth for a longer period of time. This is a decision that should not be taken lightly.
Increase the Down payment
Increasing your down payment can also get you better rates because you’re lowering the amount of money you’re borrowing in the first place. The less money you borrow, the better your interest rate will be in most cases.
I’m Stuck…Can I Change My Rate?
It kind of depends on the type of loan you have. Personal loans and mortgages can often be refinanced. This means that you break the current contract you’re in and take out a new one. You might do this for a whole host of different reasons. In the case of a personal loan, you may want to consolidate a number of different loans into one larger loan. As it relates to mortgages, you could refinance for a better rate or lower payment, and even refinance to remove cash out of your mortgage via your home’s equity. Refinancing is a huge deal so make sure you have a firm understanding of your budget and the associated costs.
Your interest rate is determined by a number of different factors, but it all starts with the Bank of Canada’s key interest rate. From there, banks and financial institutions will set their own rate and charge you appropriately according to your specific risk. You can get more favorable rates by keeping your financial house in order and understanding a bit about the current economic landscape.
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.