Interest is often called “the rent of money” because it is an amount that must be paid between the time of the loan and its complete repayment, just as we pay rent during the term of our stay in the accommodation.
How is the interest rate determined
The interest rate is a percentage of the loan amount. This rate is set based on the type of loan requested and several other factors, including:
- the key interest rate set by the Bank of Canada, which represents the rate that financial institutions must pay to borrow money. The lower this rate, the better the conditions that banks can offer you, if your credit report is good.
- your credit rating, determined from your credit file. A better record and a higher credit score can lead to a lower interest rate. That being said, good credit management could help your credit rating and the interest payable when borrowing.
Different interest rates
Depending on the type of credit you use, the interest rate can vary greatly. For example, the interest applicable to a line of credit is lower than that charged for a personal loan.
The calculation of interest
The interest to be paid for a loan, line or card is calculated according to pre-established rules. How the amount to be paid is calculated will have a big impact on the total interest
Note that this amount of interest is often added at the end of each month to the balance you owe. .
Interest at your service
If you borrow money, you have to pay interest. But if you put your money in a certificate of deposit, for example, you are the one who will receive interest. In this case, you are the lender and the interest compensates for the fact that you do not have access to this money while the borrower uses it.
It is thanks to the power of compound interest that it is possible to grow your savings. If you reinvest the interest you receive, it will also earn you interest, which will grow your savings over time.
The different variants of variable rate mortgages
The capped variable rate loan
To afford some security compared to a “classic” variable rate loan, the borrower can choose to take out a capped variable rate mortgage. If it will continue to evolve upwards or downwards, the latter will however be subject to a framework contractually capped at 1%, 2% or even in certain cases at 3%. The cap (or ceiling) represents the maximum change in the rate during the loan, upwards or downwards.
The capped adjustable-rate loan with capped maturities
In the event of a sharp increase in the Euribor, and even if the loan is taken out with a capped rate, the borrower may see his monthly payments vary very sharply upwards, increasing his debt ratio and reducing his remaining life. The adjustable-rate loan with capped monthly payments (or capped maturities) makes it possible to limit the monthly repayment of the credit, so as not to asphyxiate the borrower in the event of a rise in rates.
The maximum increase is generally limited by the price index provided by INSEE. If the change in the Euribor index is greater than the Insee index, the loan interest rate will not change. But the duration of the loan will be automatically increased.
This extension of duration is usually capped at 5 years .
Uncapped variable rate credit with uncapped maturities
Only the informed borrower should opt for this type of mortgage. Indeed, the variations of the reference index are not reflected here on the level of the rate but directly on the number of monthly payments. The duration of the loan will therefore be reduced or extended and this, without any limitation.
The adjustable rate loan with double indexation
The credit is here subject to the fluctuations of two different indices: the Euribor (influencing only the interests) and the price index of the INSEE (influencing the monthly payments). The rate applied to a double-indexed loan follows the same rules as a “classic” variable rate. But the variation of his monthly payment will be subject to a progressive increase (defined in the terms of the contract).
Several possibilities may arise:
- Fall in the benchmark index : the duration of the loan is greatly reduced
- Stabilization of the benchmark index : the duration of the loan is slightly reduced
- Slight increase in the benchmark index : the duration of the loan is not subject to any variation
- Sharp rise in the benchmark index : the duration of the loan is extended
- The gradual increase in the amount of the monthly payments serves to reduce the impact of the benchmark index on the duration of the loan. We can consider here that by reimbursing increasingly large monthly payments, the borrower pays in advance part of any increases in the Euribor. It is for this reason that the duration of his mortgage is reduced when the benchmark index (Euribor) is stable.
Advantages and disadvantages of the adjustable rate loan
Advantages of the variable rate
Applied to a home loan, it allows the borrower:
- to benefit from the signature of the credit agreement, from a more advantageous rate than if he had chosen a fixed rate. The difference between these two types of rates is sometimes -2%
- to obtain an automatic reduction in its interest rate in the event of a drop in the Euribor index
Subscribing to a variable rate loan is therefore to be preferred when fixed rates are at their highest.
Disadvantages of revisable credit
Intended to evolve during the loan, a variable rate places a certain risk on the shoulders of the borrower: its possible upward trend. In the majority of cases, the borrower will go into debt throughout 12, 20, or even 30 years. It is therefore impossible to anticipate the change in rates over such a long period.