What the Bank of Canada’s latest overnight rate hike means for your finances
What happens when the Bank of Canada raises or lowers interest rates?
If the economy is struggling to grow or suffers a shock, as was the case during the COVID-19 pandemic, the Bank of Canada can cut interest rates to help stimulate economic activity. When the overnight rate falls, individuals and businesses pay less interest on new and existing loans and mortgages, and earn less interest on their savings. This usually causes them to spend more, which in turn helps strengthen the economy.
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Conversely, an economy that grows too quickly can lead to high levels of inflation. In this scenario, the Bank of Canada could raise the overnight rate, forcing individuals and businesses to pay higher interest on loans and mortgages. This discourages them from borrowing, reduces overall spending, and generally keeps inflation in check.
How often does the Bank of Canada reset interest rates?
In 2020, to help Canadians anticipate and prepare for interest rate changes, the Bank of Canada introduced an annual eight fixed interest rate announcements. It is on these specific dates that it reports whether or not there are changes in the overnight rate. In special circumstances, such as national emergencies, it may announce rate changes on other unspecified dates, as it did on March 13 and 27, 2020, in response to COVID-19.
Historically, the overnight rate has fluctuated with large-scale events affecting the economy. In the wake of the 2008 financial crisis, the rate fell from 4.50% to 0.25%. Between 2010 and 2018, it gradually increased to 1.75%. It then fell sharply in early 2020 in response to the pandemic.
What is the prime rate?
Not to be confused with the Bank of Canada’s prime interest rate, the prime interest rate is a percentage used to set interest rates on several types of loans, including lines of credit, student loans and variable rate mortgages.
Each of the big five banks — Bank of Montreal (BMO), Bank of Nova Scotia (Scotiabank), Canadian Imperial Bank of Commerce (CIBC), Royal Bank of Canada (RBC) and Toronto-Dominion Bank (TD) — can define its own prime rate, but they tend to use the same rate. The prime rate is currently at 5.45%
How is the prime rate set?
When the Bank of Canada raises or lowers its overnight rate, prime rates generally adjust by a similar amount. Most lenders reset their prime rate almost immediately after the Bank of Canada changes its benchmark rate.
This is why changes in the overnight rate cause a sort of domino effect on the variable rate loans offered by banks – their interest rates are usually expressed as a “premium plus or minus” a percentage. For example, a bank may offer a product at a “premium minus 1%” rate. At a prime rate of 2.45%, a product listed at “prime minus 1%” would mean the customer pays 1.45% interest.
