Finance With Rohan

Business and stocks, explained in simple words.

Tag: interest

  • How Banks Make Money, Explained Simply

    How Banks Make Money, Explained Simply

    Introduction

    Banks look like safe places to keep money. You put money in, and you can take it out later. But a bank is also a business. A business needs to earn more money than it spends. So how does a bank earn money? The answer is simple once you see the full picture. A bank earns money in a few clear ways, and the biggest way is the gap between two interest rates.

    Interest is extra money paid for using money. When you borrow money, you pay interest. When you save money in a bank, the bank pays you interest. A bank pays a low rate to savers, and it charges a higher rate to borrowers. The gap between those two rates is where most bank money comes from. The bank also earns money from fees and other services, and we will look at those too.

    What It Is

    A bank is a business that moves money between people. Some people have extra money, and they want a safe place to keep it. Other people need money now, and they are ready to pay extra to borrow it. The bank sits in the middle of those two groups. It takes money from savers, and it lends money to borrowers. That is the main job of a bank.

    A deposit is money you put into a bank account. A loan is money a bank lends to a person or a business. A loan must be paid back, with extra money added. That extra money is interest. Profit is the money a business keeps after it pays all its costs. A bank wants to make a profit, just like a shop or a café does. But it does not sell food or clothes, so it earns money in a different way.

    How It Works

    The main way a bank earns money is called the interest gap. The bank pays savers a small rate, and it charges borrowers a bigger rate. Think of it like buying low and selling high, but with money instead of goods. The bank “buys” money from savers at a low price, and it “sells” money to borrowers at a higher price. The difference is the bank’s main income.

    People who study banks have a name for this gap. They call it the net interest margin. That is a long name, so here is the simple idea. It is the gap between the interest a bank earns on loans and the interest it pays on deposits. The bank must use that gap to pay for staff, buildings, computers, and safety checks. The bank must also set money aside for loans that are never paid back. What is left after all those costs is profit.

    Fees are the second way banks earn money. A fee is a small charge for a service. Many banks charge a monthly fee for a chequing account. Some charge a fee when you use another bank’s cash machine. Some charge a fee when you send money to another country. Some charge a fee when a payment fails because there is not enough money in the account. These fees add up, because millions of people pay them.

    Banks also earn money from cards and other services. When you pay with a credit card, the shop pays a small fee to the card system, and the bank gets part of that fee. If you do not pay your full credit card bill on time, the bank charges you high interest on the money you still owe. You can read more about that in How Credit Card Interest Works in Canada. Banks also earn money by helping people invest, by changing money from one currency to another, and by helping businesses with big money jobs.

    An Example With Numbers

    Let us use a simple example with easy numbers. This is an example only, not a real bank rate. Imagine a bank pays 2% interest on savings. That means a saver with $1,000 in the bank earns $20 in one year. Now imagine the same bank charges 6% interest on a loan. That means a borrower with a $1,000 loan pays $60 in interest in one year. The bank paid $20, and it earned $60, so the gap is $40.

    Now imagine the bank does this with thousands of people. It pays $20 to each saver, and it earns $60 from each borrower. The gap grows bigger with each person. But the bank cannot keep the whole $40 from each pair. It must pay its workers, keep its branches open, and keep its computers safe. It must also cover the cost when some borrowers cannot pay their loans back. So the real profit is smaller than the gap, but the gap is still the start of the profit.

    Here is a second small example with fees. Imagine a bank charges $4 a month for a basic account. That is $48 in one year for one person. That may sound small, but think of one million people paying the same fee. That is $48 million in one year from that one fee alone. In Canada, banks must offer a low-cost account for no more than $4 a month, and students can often get a no-cost account. That rule comes from the Financial Consumer Agency of Canada, which is the group that watches over banks for consumers. So it is worth asking your bank about a low-cost or student account.

    Common Mistakes

    One common mistake is to think that a bank just keeps your money in a big safe. Your money does not sit still in a vault. The bank lends most of it out to other people, and it keeps only a small part ready for daily withdrawals. That is why the bank can pay you interest, and it is also why the bank needs rules and safety checks. Your money is still yours, and you can ask for it back, but the bank uses it while it waits for you.

    A second mistake is to think that all your money in a bank is fully safe no matter how much you have. In Canada, deposits at member banks are protected by the Canada Deposit Insurance Corporation, which is called CDIC for short. CDIC protects eligible deposits up to $100,000 per category, per member bank. A category is a type of account, like an account in one name or a TFSA. This cover is free and automatic at member banks. It does not cover stocks, mutual funds, or crypto, and it only helps if the bank fails. To learn how to build a safety cushion of your own, read Emergency Fund: How Much Cash Should a Student Keep?.

    A third mistake is to think that banks earn money only from loans. Loans are the biggest source, but fees and services matter too. That is why it helps to read your bank statement and check what you pay each month. A small fee can look tiny, but it can add up over a year. If you do not need a paid account, ask about a low-cost or no-cost account. A good habit is to check your fees once a year and ask if a cheaper account fits your needs.

    Final Thoughts

    Banks earn money in a simple way. They pay a low rate to savers, and they charge a higher rate to borrowers. The gap between those two rates is their main income. Fees, cards, and other services add more income on top of that gap. The bank then pays its costs, and what is left is profit. Once you see this, bank fees and loan rates make more sense. You can then choose an account with low fees, borrow only when you need to, and keep your savings safe.

    Quick Questions

    How do banks make money?
    Banks make money mainly from the gap between the interest they pay on deposits and the interest they charge on loans. They also earn money from fees, cards, and other services.

    Is my money safe in a Canadian bank?
    Eligible deposits at CDIC member banks are protected up to $100,000 per category, per member bank, if the bank fails. This cover does not protect stocks, mutual funds, or crypto.

    Why is loan interest higher than savings interest?
    Banks charge more on loans than they pay on savings because that gap is how they earn money and pay their costs. The bank also takes a risk when it lends, because some borrowers may not pay the loan back.

    Disclaimer: This article is for educational and informational purposes only and does not constitute financial advice.

    Sources: CDIC — https://www.cdic.ca/articles/what-happens-when-bank-faces-trouble/ ; RBC, What is CDIC — https://www.rbcroyalbank.com/en-ca/my-money-matters/money-academy/banking-basics/account-types/what-is-cdic-and-how-does-it-protect-your-money/ ; GoCompare, Net Interest Margin — https://www.gocompare.com/savings/net-interest-margins/ ; MoneySense, Why banks are slow to lower lending rates — https://www.moneysense.ca/save/banking/why-bank-are-slow-to-lower-lending-rates-but-quick-to-hike-them/ ; NerdWallet Canada, low-cost bank accounts — https://www.nerdwallet.com/ca/p/article/banking/could-you-ditch-monthly-bank-fees

  • What Is Compound Interest? The Snowball That Grows Money

    What Is Compound Interest? The Snowball That Grows Money

    Introduction

    Imagine a small snowball rolling down a hill. At first it is tiny, and it grows slowly. As it rolls, it picks up more snow. Soon it is bigger, so it picks up even more snow with each turn. By the end of the hill, it is huge. Money can grow in the same way. That is the simple idea behind compound interest.

    Interest is extra money paid for using money. When you save money, the bank pays you interest. When you borrow money, you pay interest to the bank. Compound interest is interest that is paid on your starting money and also on the interest you have already earned. Your money earns money, and then that new money earns money too. That is why people call it a snowball.

    What It Is

    Compound interest is interest on interest. It is different from simple interest, and the difference matters a lot over time. Simple interest is interest paid only on your starting money. It never changes, because it always uses the same starting number. Compound interest uses a bigger number each time, because the interest you earned is added to your money.

    Your starting money has a simple name. People call it the principal, but you can just think of it as your starting money. If you put $1,000 in a savings account, your starting money is $1,000. In the first year, you earn interest on $1,000. In the second year, you earn interest on $1,000 plus the interest from the first year. That is the whole trick. Your money grows a little faster each year, because the base keeps getting bigger.

    How It Works

    Compound interest works in small steps, one step at a time. At the end of each year, the bank adds interest to your account. Your balance goes up by a small amount. In the next year, the bank works out interest on the new, bigger balance. So you earn a little more interest than you did the year before. This keeps going, year after year, and the growth gets faster over time.

    The key is to leave the interest in the account. If you take the interest out and spend it, your balance stays the same. Then the next year looks just like the last year, and that is simple interest, not compound interest. But if you leave the interest in, it joins your starting money. Then it starts to earn interest too. That is why time matters so much, and why starting early helps even with a small amount.

    How often the interest is added also matters a little. Some accounts add interest once a year, and some add it once a month. Adding it more often means the interest starts earning interest sooner. The difference is small at first, but it grows over many years. The biggest factors are still the same three things. They are how much you start with, the interest rate, and how long you leave the money alone.

    An Example With Numbers

    Let us use a clear example with easy numbers. This is an example only, not a promise of a real rate. Imagine you put $1,000 in an account that pays 5% interest per year. The interest is added once a year, and you do not add or take out any money. In the first year, you earn 5% of $1,000, which is $50. Your balance is now $1,050. That first year looks the same for simple interest and compound interest.

    In the second year, the two types split apart. With simple interest, you earn $50 again, because simple interest always uses the starting $1,000. Your balance is $1,100. With compound interest, you earn 5% of $1,050, which is $52.50. Your balance is $1,102.50. The difference is only $2.50, but it is real. In the third year, compound interest earns 5% of $1,102.50, which is $55.13, and the balance is $1,157.63. The gap keeps growing.

    After 10 years, the gap is easy to see. With simple interest, you earn $50 each year for 10 years, which is $500 in total. Your final balance is $1,500. With compound interest, your final balance is $1,628.89. You earned $628.89 in interest, which is $128.89 more than simple interest. The formula for this is simple to read. You take your starting money, times 1.05, and you do that 10 times, once for each year. After 20 years at the same 5%, the same $1,000 would grow to $2,653.30, and that shows how time makes the snowball bigger.

    Common Mistakes

    One common mistake is to wait for a big amount before you start saving. People think $1,000 is too small to matter, so they wait. But compound interest rewards time more than size. A small amount left alone for a long time can grow more than a big amount left alone for a short time. You can start with a small amount in a TFSA, which is a Tax-Free Savings Account. You can read a simple guide in What Is a TFSA? Simple Guide for Canadian Students. The key is to start, and then to leave the money alone.

    A second mistake is to take the interest out too soon. If you spend the interest each year, you break the snowball. Your balance stops growing faster, and you go back to simple interest. That is fine if you need the money, but it is not the best way to grow savings. A better habit is to leave the interest in the account and let it work for you. If you want to compare a TFSA with an RRSP, which is a Registered Retirement Savings Plan, read What Is RRSP vs TFSA in Canada?.

    A third mistake is to forget that compound interest also works against you on debt. When you borrow money, interest can build up on the interest you already owe. That is why credit card debt can grow so fast if you pay only the minimum amount. The same snowball that helps your savings can hurt you when you owe money. So use compound interest as a friend for saving, and be careful with it when you borrow.

    Final Thoughts

    Compound interest is simple to understand, but it is powerful over time. Your starting money earns interest, and that interest earns interest too. The growth starts slow, and then it gets faster. You do not need a big amount to start, and you do not need a hard plan. You need time, patience, and the habit of leaving the money alone. Start small, start early, and let the snowball roll.

    Quick Questions

    What is compound interest in simple words? Compound interest is interest earned on your starting money plus the interest you have already earned. Your money earns money, and then that new money earns money too.

    How much is $1,000 at 5% after 10 years with compound interest? With interest added once a year, $1,000 at 5% grows to $1,628.89 after 10 years. With simple interest at the same rate, it would grow to only $1,500.

    Is compound interest better than simple interest? Yes, for saving, compound interest gives you more money over time because it pays interest on past interest too. For borrowing, it can cost you more, so it is best to pay debt down fast.

    Disclaimer: This article is for educational and informational purposes only and does not constitute financial advice.

    Sources: Investopedia definition via BridgeView Advisors — https://www.bridgeviewadvisors.com/compound-interest-2/ ; Simple vs Compound Interest, worked example — https://www.toolnimbly.com/blog/simple-vs-compound-interest-examples ; Compound Interest Formula Explained Simply — https://www.bankdepositguide.com/articles/compound-interest-formula-explained ; How compound interest works, whiteboard explainer — https://www.rekkaai.com/blog/compound-interest-explained

  • How Credit Card Interest Works in Canada

    How Credit Card Interest Works in Canada

    Introduction

    Many people in Canada use credit cards every day. A credit card can help, but it can also cost you a lot of money. This article explains it in simple words.

    What It Is

    Credit card interest is extra money you pay for borrowing. A credit card lets you borrow money to buy things. You do not pay right away. The card company pays the store. Then you pay the card company back.

    Every card has a credit limit. A credit limit is the most money you can spend on the card. When you pay some back, you can spend it again. This is called revolving credit.

    How It Works

    Each month, your card company sends you a bill. The bill shows what you spent. It also shows the due date. The due date is the last day to pay. If you pay the full bill by the due date, you pay no interest on your purchases.

    Canada has a rule about the grace period. It is the time you get to pay without interest. For federally regulated banks, the grace period is at least 21 days. So you get at least three weeks to pay in full.

    If you do not pay the full bill, interest starts. Interest is a fee for borrowing money. It is shown as a percent per year. The rate is different for each card and each kind of purchase.

    Cash advances are different. A cash advance is when you take cash out with your credit card. There is no grace period for a cash advance. Interest starts on the day you take the cash. Cash advances also have extra fees.

    A balance transfer means you move what you owe from one card to a new card. There is often a fee. Canada’s consumer agency gives one example. If you move a $1,000 balance and the fee is 3 percent, you pay a $30 fee.

    An Example With Numbers

    Let’s look at a simple example. Pretend you spend $1,000 on your card. Pretend the card charges 20 percent a year. If you pay the full $1,000 by the due date, you pay $0 in interest. That is the best choice.

    But what if you do not pay it back? At 20 percent a year, $1,000 would cost about $200 in interest in one full year. That is about $16 to $17 each month. The longer you wait, the more you pay.

    • 21 days — the shortest grace period for federally regulated banks
    • $0 — the interest on purchases if you pay the full bill by the due date
    • $30 — the fee to move a $1,000 balance at 3 percent
    • 20 percent — the rate used in the example above

    Common Mistakes

    One big mistake is paying only the minimum. The minimum payment is the smallest amount you must pay each month. If you pay only the minimum, the rest stays. Interest keeps growing. The debt can last for years.

    Another mistake is missing a payment. If you miss the minimum payment, your rate can go up. You can also lose a low rate that was part of a deal. Always pay on time.

    A third mistake is taking cash advances. Many people do not know that interest starts right away. Cash advances are one of the most costly ways to use a card.

    One more mistake is saying yes to a higher credit limit. A higher limit means you can spend more. It does not mean you should. A card company must ask you before it raises your limit. Think twice before you say yes.

    Final Thoughts

    Credit card interest is simple once you know the rules. Pay the full bill by the due date, and you pay no interest on your purchases. Pay less, and interest starts to grow. Cash advances cost the most, so try not to use them. A card can help you, but only if you stay in charge of it. I wrote about what I learned about credit cards as a student. It also helps to have an emergency fund first.

    Quick Questions

    What is credit card interest?
    It is the extra money you pay when you do not pay the full bill by the due date.

    How can I pay no interest on my credit card?
    Pay the full bill by the due date. Then you pay no interest on your purchases.

    What is the grace period for a credit card in Canada?
    For federally regulated banks, the grace period is at least 21 days.

    Disclaimer: This article is for educational and informational purposes only and does not constitute financial advice.

    Sources: Financial Consumer Agency of Canada — How credit cards work; Financial Consumer Agency of Canada — Credit cards

    Photo: A hand holding a black credit card. Photo via Pexels.

  • What I Learned About Credit Cards as a Student

    What I Learned About Credit Cards as a Student

    Introduction
    I got my first credit card offer as a student. It looked exciting. A small card could buy things now. I could pay later. That sounded easy. It sounded almost like free money. It is not free money. I learned that lesson slowly. This is what I learned.

    What I Learned
    A credit card lets you borrow money from a bank. You do not own that money. You must pay it back. Each card has a limit. A limit is the most you can borrow on that card. Each month, you get a statement. A statement is a list of what you bought. It also shows a due date. The due date is the day you must pay by. You can pay the full amount. Or you can pay a minimum payment. A minimum payment is the smallest amount the bank asks for that month. It sounds helpful. But it can be a trap. If you pay only the minimum, the rest stays as debt. Debt is money you still owe. Then interest is added. Interest is the extra cost of borrowing. Many credit cards charge interest of about 20 percent a year. That is high. So a small purchase can cost much more over time.

    A Mistake or Surprise
    My surprise was how fast interest can grow. I thought the minimum payment would solve the problem. It did not. It only slowed the problem down. The debt stayed. The interest kept adding. I also learned about a credit score. A credit score is a number. It shows how well you handle borrowed money. Paying on time can help your score. Missing payments can hurt it. A good score can help later in life. For example, if you spend $20 a week on a card, that is a general example. It is not my real spending. The point is simple. Only spend what you can pay back in full.

    What I Do Now
    Now I keep it simple. One card is enough at the start. I do not need many cards. I set a reminder before the due date. I check my statement each month. I look for mistakes. I try to pay the full amount. If I cannot pay in full, I pay as much as I can. I do not buy things just because I have a card. I ask one question first. Can I pay for this from money I already have? If the answer is no, I wait. That rule helps me stay in control.

    Final Thoughts
    A credit card is a tool. It is not free money. It is borrowed money. The minimum payment trap is real. Interest of about 20 percent can make debt grow fast. Paying in full is the safest habit. Your credit score grows from small, steady, on-time payments. Start with one card. Learn the rules. Use it slowly. That is what I am learning to do.

    Disclaimer: This article is for educational and informational purposes only and does not constitute financial advice.

    Sources: Financial Consumer Agency of Canada (FCAC) / Canada.ca – Credit cards: https://www.canada.ca/en/financial-consumer-agency/services/credit-cards.html