The central bank’s overnight interest rate sets the tone for the prime rates offered by banks. We explain what changes in the policy rate mean for you.
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The Bank of Canada has raised its policy interest rate by half a percentage point for the first time in decades, a move intended to slow runaway inflation. The rate hike brings the Bank’s policy interest rate, also known as the overnight rate, up to 1% from the previous 0.5%.
It’s the second time the Bank has raised its target interest rate this year, and the first time it has done so beyond a 0.25% increment since May 2000. After maintaining a benchmark rate of 0.25% in January—a record low first implemented in March 2020 in response to the COVID-19 pandemic—it increased the rate to half a percentage point in early March.
Inflation, as measured by the consumer price index (CPI), has fuelled the need for a tightening of monetary policy in Canada. In February 2022, inflation reached 5.7%, marking the largest gain in consumer prices since August 1991, according to Statistics Canada. As part of its mandate, the Bank of Canada aims to maintain inflation at a rate of 2% per year.
“Inflation is being driven by rising energy and food prices and supply disruptions, in combination with strong global and domestic demand,” the Bank said in a statement accompanying its April rate-hike decision. “CPI inflation is now expected to average almost 6% in the first half of 2022 and remain well above the control range throughout this year.”
The Bank expects inflation to remain above its target until 2024, noting that there’s “an increasing risk that expectations of elevated inflation could become entrenched.”
Hikes in the Bank’s target overnight rate are intended to help keep inflation in check. The increases also have far-reaching implications for your finances, whether you’re applying for a mortgage, repaying a student loan or living off retirement income. We take a look at how the Bank’s policy rate works, how it is set and what it means for you.
To understand the Bank’s policy interest rate, also known as the overnight rate, it helps to start by defining inflation.
Inflation is a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money. Gradual inflation over time helps keep the economy strong by making increases in wages and expenses predictable for businesses and consumers. But inflation that exceeds the norm makes it more difficult for people to afford everyday expenses.
The Bank aims to keep inflation stable at 2%—or between the target range of 1% to 3% per year. That’s where the overnight rate comes into play: It is the Bank’s primary tool for controlling inflation. The overnight rate influences how the banks will set their own rates. It acts as a sort of barometer for the rate at which major banks borrow and lend among themselves. When the Bank raises the overnight rate, it becomes more expensive for banks to borrow money, and those costs get passed onto borrowers through higher interest rates.
If the economy is struggling to grow or experiencing a shock, as it did during the COVID-19 pandemic, the Bank can slash interest rates to help boost economic activity. When the overnight rate falls, people and businesses pay lower interest on new and existing loans and mortgages, and they earn less interest on savings. This generally leads them to spend more, which in turn helps strengthen the economy.
Conversely, an economy that is growing too quickly can lead to high levels of inflation. In this scenario, the Bank might raise the overnight rate, forcing people and businesses to pay higher interest on loans and mortgages. This discourages them from borrowing, reduces overall spending and typically brings inflation under control.
In 2020, to help Canadians anticipate and prepare for changes in the interest rates, the Bank introduced a schedule of eight fixed policy rate announcements per year. It’s on these specified dates that it reports whether or not there are changes the overnight rate. In special circumstances, such as national emergencies, it may announce rate changes on other non-specified dates—just as it did on March 13 and 27, 2020, in response to COVID-19.
Historically, the overnight rate has fluctuated based on large-scale events affecting the economy. On the heels 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.
Not to be confused with the Bank’s policy interest rate, the prime interest rate is a percentage used to set interest rates on several different types of loans, including lines of credit, student loans and variable-rate mortgages.
Each of the five major 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 set their own prime rate, but they tend to use the same rate. Today’s prime rate is 3.20%.
When the Bank of Canada increases or slashes its overnight rate, prime rates typically adjust by a similar amount. Most lenders reset their prime rate almost immediately after the Bank changes its benchmark rate.
That’s why changes in the overnight rate prompt a sort of domino effect on variable-rate loans offered by banks—their interest rates are typically expressed as “prime plus or minus” a percentage. For example, a bank may offer a product at a rate of “prime minus 1%.” At a prime rate of 2.45%, a product listed at “prime minus 1%” would mean the customer pays 1.45% in interest.
When prime rates increase or decrease, so do variable rates. This domino effect can impact borrowers with a variable-rate mortgage, home equity line of credit (HELOC), student loan, line of credit or another type of variable-rate loan. Mortgage analyst Robert McLister has noted that “a 25 [basis points] boost to prime lifts payments on adjustable-rate mortgage payments by roughly $12/month per $100,000 of borrowing.”
“If the prime rate goes up by 1%, people who are spending a couple thousand dollars a month on their mortgage could see that [amount] rise substantially,” says Jesse Abrams, CEO of online mortgage broker Homewise. “Over five years we could be talking $30,000 to $40,000. That one extra percent can be pretty significant.”
However, this does not apply to borrowers with a fixed-rate loan, such as a fixed-rate mortgage. A fixed rate is “locked in,” meaning the rate is guaranteed by the lender for the duration of the loan or mortgage term. In this instance, the borrower continues to pay the same rate regardless of what happens in the outside market.
Changes in the prime rate also influence the interest earned in high-interest savings accounts (HISAs) and other vehicles, like guaranteed investment certificates (GICs). When the overnight rate increases, individuals can earn higher interest on their savings, because financial institutions have more latitude to compete on the interest rates they offer. Conversely, individuals who are retired or living off fixed income from a savings fund can be negatively impacted when the overnight rate drops.
While the overnight rate is generally expected to continue rising this year, there are ways for borrowers to prepare. Start by keeping track of the next policy rate announcement, then anticipate and plan around what an increase or decrease in the rate will mean for your finances.
If you have a variable-rate mortgage, you can use a mortgage payment calculator to determine what your new recurring payments will be. It may be time to consider locking into a fixed-rate mortgage. And if you’re in retirement or planning to retire soon, you may wish to speak to a financial planner about your options.
What the future holds relies heavily on the stability of the Canadian economy. The Bank’s interest rate was slashed to its current low when the economy needed a boost, and a gradual return to higher rates would suggest the economy is recovering well. So while higher rates could make borrowing and paying off debt more difficult, for many people, they may also be a sign of better times ahead.
This article was first published on Feb. 28, 2022. It was last updated on April 13, 2022.
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What about the idea of a blended mortgage? Knowing rates are going to rise, an option is to talk to your bank about blending the current rate with the rate you are paying and locking in for the next 5 years. It’s a good way to extend your lower rate payment longer especially if your mortgage was coming up for renewal in the next year or two.
Very excited to finally see savings accounts (1.7%) and GIC rates (3.1% for a 1-year term) on the rise. Obviously locking in a 5-year term now makes no sense so I’m wondering what MoneySense suggests a good strategy would be for savers?
Great question! Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.