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Overnight rate vs. prime rate explained

by Corben Grant on 05 May 2022

These days, everyone has their eyes on the Bank of Canada as they are in the progress of gradually raising interest rates. As the Bank of Canada rate goes up, so do mortgage rates, which affects anyone who has a mortgage in Canada.

You may be wondering how that change actually happens. After all, you probably have a mortgage with one of Canada's big banks, not the central bank. How come the central bank's interest rate is still so much lower than the interest rate you are being charged?

Well, though the Bank of Canada may not offer mortgages directly, it does play a major role in influencing Canadian financial institutions. Because of this, all decisions made by the central bank have effects on all the other lenders in Canada. The relationship between the Bank of Canada’s target overnight rate and Canadian banks’ prime rate is relatively simple but also very important as it can affect how much you pay when you borrow money.

In this article, we are going to look at exactly how the Bank of Canada sets its interest rate, how it affects other banks’ prime rates, and what it means for your mortgage rates.

What is the Bank of Canada (BoC)?

The key to understanding how interest rates function in the Canadian financial system all comes down to the Bank of Canada. The Bank of Canada (not to be confused with the Royal Bank of Canada or the National Bank of Canada, which are completely separate entities) is a government-operated bank that serves as the central Bank of Canada.

The Bank of Canada has been the nation's official central bank since its creation in 1934 and its stated goal is to "promote the economic and financial welfare of Canada".

Operations of the Bank of Canada

The bank does not operate like most other banks you may be familiar with. For example, it does not offer banking services to the general public and there is a good chance there is no branch nearby you anyway. As an individual, you can't walk into your local Bank of Canada and take out a loan or open a savings account. Rather, the Bank of Canada primarily deals with Canadian financial institutions and other government organizations. In addition, the bank is responsible for directing the country's monetary policy, maintaining the stability of our currency, and is the sole issuer of Canadian banknotes (but not coins, which are issued by the Royal Canadian Mint).

The largest focus of the Bank of Canada's direction of monetary policy is to maintain an acceptable level of inflation, primarily by influencing interest rates. The current target for inflation within the Bank of Canada is 1%-3% and the bank is currently altering interest rates in order to return to those levels.

How does the Bank of Canada set the overnight rate?

Because the Bank of Canada has all other major banks as clients and is one of the primary sources of Canadian banknotes, essentially, all money in the country flows through their vaults at some point.

It is also crucial to understand that though banks may seem to be competitors in the industry, they also work closely together. In general, banks like to keep their money in motion so they can continue to earn from their interest rather than just holding onto it. When a bank has too much money on hand, they want to lend it out, and when a bank has too little, they want to borrow some more.

Banks work together to hit the target overnight rate set by BoC

Banks make deals with each other each day to balance their holdings, but they aren't going to do so without a price. Just like you are charged interest for your loans, banks charge one another interest on the money they borrow. This is often known as the overnight rate, which represents the cost of borrowing money "overnight" or until the next business day.

Banks may also lend and borrow from the Bank of Canada. In order to reach a target overnight rate, the Bank of Canada borrows money at a lower interest rate than any other bank while it lends out money at a rate higher than other banks. As a last resort, the Bank of Canada will lend or borrow money from other banks, though they usually try to avoid this. In order to avoid losses from the Bank of Canada's less favourable rates, the banks are forced to work with one another to remain within the Bank of Canada's set bounds. This goal rate is called the policy interest rate or the target for the overnight rate.

Because the rate represents the most fundamental cost of cash to the banks, they will never offer a rate lower than their own overnight rate to customers. This means that, by changing its target rates, the Bank of Canada makes the cost of borrowing cheaper or more expensive to financial institutions, which then gets passed on to consumers when they borrow money.

What is the prime lending rate?

The prime interest rate is a rate set by each bank to determine the amount of interest they charge to consumers. Though each bank sets its own prime rate, they generally work to keep their prime rates in line with one another.

The current prime rate in Canadian banks as of the time of writing is 3.2%. This rate was increased from 2.7% in April in response to the Bank of Canada raising its policy rate. The central bank increased its rate by 50 basis points and the banks, in turn, increased their prime rates by the same amount, demonstrating just how closely connected these two rates are.

The prime rate represents the base interest rate that a bank will lend money for in order to cover the overnight rate as well as account for their own operating costs. This does not mean that this rate is the actual rate that customers will be offered, but it serves as the basis for the interest rate they are offered.

How the prime rate affects different financial products

Lending for something like a Home Equity Line of Credit is generally pretty low risk for a bank because it is secured against a valuable asset. This means that the banks are willing to offer low interest, usually just around 0.5% above their prime rate.

On the other hand, something like credit lending is unsecured and presents more risk. For this reason, credit cards that set their interest based on the prime rate will often offer rates like "prime + 6.99%".

Furthermore, there are cases where lenders may even be offered a rate below the prime rate. For example, for lenders of variable-rate mortgages who have a great financial profile, the banks may offer a discount from the prime rate.

What does the prime rate mean for your mortgage?

Because the prime rate is the base cost of borrowing from a bank, it can also affect your mortgage rates. In general, the prime rate mostly affects variable-rate mortgages. With a fixed-rate mortgage, your rate will not change over its term even if the prime rate changes. The rates offered for fixed-rate mortgages and other fixed-rate loans are more closely tied to government bond yields.

The bank does not simply change variable rates because they feel like it, rather, they do so in response to the increased cost of borrowing for themselves.

The interest rate you are charged on a variable rate mortgage moves with the prime rate, but it may not be set at the prime rate specifically. Rather, your rate is determined by the prime rate plus or minus a delta that acts as a markup or discount. Though your rate can change, the actual equation that calculates your interest (prime ± delta) is fixed.

The rate you are offered will be determined based on a number of factors. These may include your credit score, the size of the loan, the size of your down payment, your general financial situation, and more.

Effect on existing mortgages

When the prime rate changes, your interest rate does as well. Luckily, most variable-rate mortgages have fixed payments, meaning the amount you pay remains the same but the amount of that payment that goes towards interest changes.

The result is a change in the length of time it takes to pay down your mortgage. If rates go up but your payments stay the same, it will take you longer to pay down your mortgage, whereas if rates fall, you will be able to pay down your principal faster.

Effect on new mortgages

If you are looking to get a new mortgage, you will be required to decide between a fixed or variable rate mortgage. It’s crucial to understand the way that the prime rate can affect your mortgage before you buy.

This is also important if you are planning on buying soon, especially with ongoing rate hikes. If you are comparing the price difference between a variable and fixed-rate mortgage now, the difference may very well be different in a few months' time.

While variable rates may offer a lower price now, you need to understand how rates can increase in the future and end up costing you money. Fixed rates are generally charged a higher amount of interest, but you have the benefit of knowing you will pay at the same rate for the entire mortgage term.

What other effects does the overnight interest rate have?

The prime rate and the overnight rate affect more than just mortgages as well. Because the rate represents the bank's cost of borrowing, the prime rate can affect all kinds of lending. As mentioned before, this can include some credit cards, as well as home equity lines. In addition, other personal lines of credit and personal variable rate loans will be affected by the prime rate as well.

How the overnight rate affects inflation

The overnight rate also has a large effect on how fast inflation can grow. The way that inflation works is complex, but it is generally measured by the consumer price index, which measures the rate of price increases (not the actual value of price increases). By slowing the rate of price increases, inflation is said to go down.

When the bank lowers its rates people and businesses pay lower interest, which encourages spending and borrowing. When the Bank of Canada increases its overnight rate, the cost of borrowing gets passed on to consumers. This discourages borrowing and spending and encourages saving. Because people are spending less, companies can not afford to raise prices as quickly and will try to keep them the same or even lower to keep demand high.

This relationship is well documented and has been used by the central bank in the past to reduce inflation successfully. However, the Bank of Canada can only do so much as price increases can also come from external and international sources beyond their influence.

Conclusion

Interest rates on their surface may just seem like small numbers, but the big fuss about them is definitely justified. The Bank of Canada's interest rate has effects on almost the entire Canadian financial system and its knockdown effects directly affect millions of Canadians when it changes.

Almost everyone is going to be a borrower at some point in their lives, be it for a home or other expenses, and understanding the bank's prime rates is an important way to make sure you make the right decisions.



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