It’s hard to think that only one personal finance number will define the entire course of your life, but it’s true. There’s only one. And it’s not your credit score. It’s your interest rates. More specifically, your compounded interest rates.
Interest rates have the power to passively make you a millionaire when you retire or the power to drive you into bankruptcy before you hit 30. To be honest, I never really thought much about interest rates because I always paid my credit card off in full by the end of the month, but that changed when I got a mortgage. All of a sudden, a difference of a tenth of a percent made a huge impact on my mortgage.
For example, I did the math and if my interest rate was .5% higher on my mortgage, I would have to pay about $62 a month more on my mortgage (which doesn’t sound bad) but would mean I would pay over $20,000 more interest over the course of my mortgage term. And that’s a lot of money that goes directly to the bank (and not to actually paying off my home)
So today I wanted to talk about what interest rates are and what you can use them to your advantage and to avoid crippling debt.
What are interest rates?
Interest rates are basically the percentage rate or which money is either given or taken from you depending if you invest your money or borrow money (most of the time its borrowing). So if you borrow $1000, and the interest rate is 10%, you will have to pay $1100 back. Pretty simple, right?
It is a simple concept, but the simple problem becomes a complex problem when the interest is compounded. What does that mean?
Compounded interest is basically interest on interest So if you have a loan that is $1000, they will not only collect the 10% interest on that loan for the first month which is $10, the bank will continue to calculate interest on the new amount ($1100) which is $10.10 and so on.
The worst and best thing in the financial world is compounded interest. You can work it to your advantage if you invest your money, and it can suffocate you with debt if you have a lot of outstanding payments. How can you get better interest rates?
In every financial conversation, you should be asking about interest rates. One of the most important parts of personal finance is ASKING about what you don’t know.
These are 4 ways that you can make the most of interest rates and learn when to take advantage of them and when to avoid them.
1. Find A High Savings Interest Account
When you deposit your money, it may not seem like a big deal whether you choose to deposit it into chequing or savings. It certainly didn’t seem like a big deal me when I was 15 and had just opened up my first bank account.
But there is a difference. A huge difference actually. Money that goes into your savings account accrue compounded interest whereas money in your chequing account does….nothing. It sits there and unless you’re frequently using it, it will not keep up with inflation. Most savings account these days (2019) give about 1% interest, which is actually very little and barely keeps up with inflation. However, there are high-interest savings accounts like a TFSA or you can go through one with WealthSimple or WealthBar – online investment companies who also offer high-interest savings accounts. These accounts are so important because although interest rates don’t seem like a big deal now, over time, they make a big difference. And this is for money just sitting there.
If you don’t have a lot of money in savings to open up an extra high-interest savings account, try using it for your emergency fund (3-6 months of your expenses). That way, the money is still very liquid and easily accessible, but it doesn’t have to be extra work. Also, that means your emergency fund is also keeping up with the rate of inflation so if you do incur an emergency in the future, your money would have kept up with it.
If you’re interested in opening a high-interest savings account, I use Tangerine Bank and love it. The great thing about Tangerine is that ALL transactions are free because many banks will charge you for transactions on your savings account (including depositing money) and that can really deter people from utilizing high-interest savings account. Plus, Tangerine always has promotions going on, I’m frequently getting a promotional interest rate of 2.75%. To get started (and to get a free $50 on me!), sign up with my Orange Key: 44592405S1.
When looking for a high interest savings account, also look for credit unions or online banks as opposed to traditional banks as they often have better rates. I’ve saved so much by switching from a bank to a credit union.
2. Never sign up for a credit card with high interest rates.
The average credit card interest is 19.99% which is still insanely high, but the worst ones can be 29.99% or higher. This is especially true for in-store credit cards where the interest rates can be sky-high.
Credit card companies will try to lure you in by stating that you’ll get X amount off today if you sign up for the credit card or you’ll get X amount cash back from all the purchases you make in this store or a certain category.
And stores and credit companies bank on you not being able to pay your credit card in full every month.
For example, if you charge $1000 on a credit card with 20% interest, and you aren’t able to pay it off by the end of the month (and only pay off the minimum balance), than next month you not only owe $1,000, but you owe 20% on that new amount as well. If you were to only pay off the minimum balance credit card at a 20% interest rate, it would take you over 10 YEARS to pay it off and you would have paid an additional $900+ in interest (based off the calculation of the Credit Card Payment Calculator provided by the Government of Canada).
So if you are not able to pay your credit card balance in full, those “savings” disappear quick. And even if you do pay off your credit card every month in full, remember that emergencies and slip-ups will come up. Sometimes you might have to carry a small balance (even though you should be at least paying off the minimum balance or you might forget to pay your credit card one month because you forgot the deadline date. Trust me, that’s happened to me before and it’s an unfortunate part of getting older.
3. Start with low-risk investing to compound your interest.
It’s easy to think that investing is means having to invest in the stock market and buy bonds. But those kinds of investments are actually dangerous and volatile if you don’t know what you’re doing (trust me, I’ve lost a lot of money trying to be that kind of investor). And really, those kinds of investments don’t really rely on interest rates. Yes, to an extent, businesses are affected by interest rates set by banks and that affect those stock holdings because the economy is all connected…..but really, they aren’t directly affected by interest rates.
To use interest rates to your advantage, look into low-risk investing such as buying GICs or mutual funds through your bank or opening up a retirement account. These types of investments allow you take advantage of the interest rates set by banks by buying safe accounts.
4. Open up a retirement account to maximize interest rates.
Using interest rates to your advantage is a long term game, which is why so many people don’t want to play it. Of course, it’s more enticing to buy the latest stocks and hot investments (I’ve been there!) and in comparison, retirement savings sound so ….. well boring. But retirement is is really a “savings” account, if you go through an RRSP, 401K or a pension, it’s actually an investing account.
Using compounded interest, even a small retirement fund, can grow massively in 20,30, 40 years when you are ready to retire. So to make the most of long term interest rates, open a retirement fund. And if you already have one – read up on your contribution limits to ensure you’re maxing it out!
Retirement sounds like an un-fun investment account because it’s so far away. But that money will not only be worth more if you grow it as an investment account, but it will also actually be more valuable. What do I mean by that? Well making money and working is easier when you’re young, but there will come a day when it’s not so easy anymore. And having even that extra $100 to have a caretaker nurse or help you pay for an unexpected expense in your 60s when you can’t easily take on another side hustle or shift at work will be so much more important than spending that extra $100 on an outfit you wear a few times then end up donating to GoodWill.
Interest rates can be the best or worst thing that happens to your financial life as an adult. Utilizing interest rates to your advantage is not only important but understanding how it works will make your big life purchases that much more easy.