Why is there a difference between the interest rate of the Bank of Canada and the rate my bank is giving me?
Saturday Dec 10th, 2022
On December 7th, the Bank of Canada (BoC) raised overnight interest rate by 50 basis points to 4.25%, resulting in Prime Rate of 6.45%.
So why are the interest rates offered by the banks much higher than those set by the Bank of Canada?
Let's start by explaining what an Overnight Interest Rate is.
The overnight interest rate is the interest rate banks charge each other to cover their short-term daily transactions. The Bank of Canada sets the target for the overnight rate, a half-percentage-point band. For example, if the band is 2% - 2.5%, the bank will pay 2% interest on money deposited by other banks and charge 2.5% on the money they lend to other banks.
All major banks and financial institutions use overnight rates as a guideline for their prime lending rates.
What is a Prime Lending Rate?
The Prime lending rate, also known as a Prime rate, is the annual interest rate Canada's major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages. In other words, it is the rate that banks charge their clients for borrowing money. Whenever the Bank of Canada changes the overnight interest rate, the banks also follow and change their prime rate.
Overnight Interest rate vs Prime Rate
The prime rate is driven by the overnight rate as set by the Bank of Canada. When the BoC raises the overnight rate, it becomes more expensive for banks to borrow money, and they raise their respective prime rates to cover the added costs. And vice versa, banks usually lower their prime rates by the same amount when the BoC lowers the overnight rate.
How changing interest rates will affect mortgages?
There are two types of mortgages in Canada – fixed and variable. Fixed mortgage guarantees the same mortgage rate until it is time for renewal. When you get a variable mortgage, the rate might fluctuate depending on the situation on the market. The rate is prime plus or minus a certain percentage for variable mortgages. That means whenever the prime rate increases, your mortgage payment goes up as well (plus/minus the percentage set in the mortgage agreement); conversely, whenever the prime rate goes down - same as your mortgage payment. Usually, variable mortgages have lower rates than fixed ones, making them more
attractive at first glance. But it would be best if you remembered that there is always the risk of changing the rate before the mortgage reaches its term.
If you want to know how raising interest rates in Canada will influence the real estate market and what strategy you need to implement in the coming months, do not hesitate to contact your trusted investment advisor.