Anatomy of an interest rate

< Back to all articles

Interest rate. A term you’ve probably heard and likely have a general understanding of. But what exactly is an interest rate? And how is it calculated? And who decides what it should be, anyway? We chatted with Neil Lowry, Regional Manager, Member Experience at Valley Credit Union to get some of the basics.

First things first, what exactly is an interest rate?

An interest rate is essentially the cost of borrowing money. It’s a premium that is charged on funds being lent, which can include anything from mortgages, to credit cards, to car loans, etc.

“Financial institutions are businesses and interest rates serve as a source of revenue when it comes to offering the service of lending money,” says Neil.

Got it. So how is an interest rate calculated?

The Bank of Canada determines what the prime—or baseline—interest rate is based on a variety of factors like inflation, strength of the dollar, and the overall economic outlook.

The rate is fixed, but eight times per year, the Bank of Canada has scheduled announcements where they can opt to adjust the interest rate or keep it as is.

What does that mean when it comes to borrowing money?

What that means at a financial institution can vary per institution. “Typically, interest rates are determined based on the prime rate, plus a premium that compensates for the risk that is involved in lending money,” explains Neil.

For instance, if the prime interest rate is 1.25%, a financial institution might charge prime plus an additional 2%, making the total interest rate on any borrowed funds 3.25%. Interest rates can be different for various products and services and can change depending on the financial institution. That’s why it’s always best to do your homework and shop around to get the rate that’s right for you.

“Credit unions actually have a lot of input when it comes to interest rates,” says Neil. “Basically, we have a grid that covers several different risk factors when it comes to lending money. Based on what we know about our members, we can sometimes offer more flexibility than other financial institutions when it comes to determining an interest rate.”

Looking for more great financial advice? Find your nearest credit union to book an appointment with one of our financial experts.