If you’ve never given much thought to interest rates, you’re not alone. Interest rates are essentially the cost of borrowing money or, more specifically, the lender’s rate for assuming all the risk of providing services. Interest rates play a crucial role in the economy’s ability to function, as they keep people lending, borrowing and spending. However, prevailing interest rates are always in flux. Not only do interest rates vary based on the lender and your creditworthiness, but also various outside factors. Whether you’re a lender, borrower or investor, it’s important that you understand the reasons for the changes and the forces that drive them.
Supply and Demand
Supply and demand are the primary factors that affect interest rates. When the demand for money to borrow goes up, so too will interest rates. Likewise, when the demand for credit goes down, interest rates will decrease along with it. Conversely, an increase in the supply of credit drives down interest rates, while a lack of credit may cause rates to soar.
What affects available credit?
The amount of money made available to borrowers directly impacts credit supply. More money goes into the economy when consumers open bank accounts. For instance, when you open a checking or savings account, you are essentially lending money to the bank. The bank can use your money for investments and other business activities, such as lending money to other consumers who want to buy a home, purchase a vehicle, etc. The more money you put into your account, the more money banks can lend, which means more credit available to the economy. When bankers withdraw funds, however, credit supply decreases, which increases the price of borrowing.
Another factor that affects credit supply is borrowers’ repayment habits. When a borrower chooses to defer the repayment of a debt or loan for a month or more, it not only increases what he or she will owe in interest but also decreases the amount of credit available to others. This, in turn, increases interest rates.
Inflation also affects interest rate levels. As inflation rates increase, interest rates are likely to rise along with it. This is because lenders will likely need to charge more for their risk and services. It is an effort to compensate for the decrease in purchasing power for the money they have yet to receive.
Inflation Target Control
The Bank of Canada and the federal government introduced inflation target control in 1991. It is an attempt to preserve the value of the Canadian dollar and keep inflation stable, low and predictable. Inflation target control is a part of the government’s overall monetary policy. The objective of the policy is to encourage long-term investment in the Canadian economy by making spending and investing less risky.
Inflation target control is at the heart of the monetary policy. The target is 2%, which is the midpoint between 1% and 3%. The federal government and Bank of Canada review the overall target every five years. But, the Bank’s Governing Council keeps an eye on it daily so as to advise its decisions regarding policy interest rates. The Council may adjust the policy interest rate settings so as to ensure a stable economic environment over the medium term. It announces these changes eight times a year.
Inflation target control also informs overnight rates. The overnight rate, or key policy interest rate, is the rate that the Bank expects lenders to use for one-day (or overnight) loans. This rate ultimately determines the rates for mortgages, consumer loans and other types of lending.
The key policy rate further influences short-term loan rates. To make sure inflation is on target, the Bank may lower or raise the key policy rate accordingly. For instance, if inflation is above the target, the Bank may raise the overnight rate in an effort to get lenders to do the same. Doing so discourages consumer spending and borrowing for the time being, which effectively serves to ease the pressure on current prices.
On the other hand, if inflation is below the target mark, the Bank may lower the overnight rate. This encourages financial institutions and lenders to do the same with their rates and therefore encourages borrowing and spending.
Despite popular belief, the Bank does not increase or decrease overnight rates for its own benefit. Rather, it does it to protect against significant inflation and deflation and to preserve overall economic health.
The Bottom Line
Ultimately, interest rates are influenced by economic conditions and, conversely, they influence economic conditions. As a result, interest rates often serve as key indicators of the economy’s health.
Despite trends, some lenders tend to offer better interest rates than others on a consistent basis. You can find loans from those lenders via our personal loan search engine. If you’re interested in borrowing money for any number of reasons, shop for the best rates your credit can get you.