If you’ve ever read the financial section of the newspaper, had a conversation with a lender, or someone in your family who loves talking about money or the “big banks” then you’ve probably heard the term prime rate. What you might not know is exactly what prime rate means and how it affects almost all lending products and therefore your financial life.
Since the prime rate does have such a large impact on the interest rates you’ll be offered by banks and other traditional financial institutions, we think it’s important that all Canadians know what it is and how it can affect specific aspects of their financial lives, now and in the future.
Prime Rate Explained
Prime rate, also often referred to as the prime lending rate, is the annual interest rate on which major Canadian financial institutions base their lending rates for variable loans or lines of credit.
Let’s say you apply for a mortgage with your bank and decide on a variable interest rate, the interest rate that you will be offered is based on, or tied to, your bank’s prime rate. It will be expressed as a certain percentage higher or lower than the prime rate. Since you have a variable rate and not a fixed rate, if your bank’s prime rate increases or decreases, so will the interest rate of your mortgage.
What type of loans are based on prime rate?
- Variable rate mortgages
- Car loans
- Personal loans
- Lines of credit
Keep in mind that not all interest rates for mortgages, car loans, etc. are based directly on a financial institution’s prime rate. But since the prime rate expresses the cost of borrowing for financial institutions, it makes sense that it also affects the cost of borrowing for the consumer.
Click here for a look at how much it costs to purchase a house in your city.
Where Does a Bank’s Prime Rate Come From?
So where does your bank’s prime rate come from and who decides what’s it’s going to be? That would be the Bank of Canada. A bank’s prime rate is based on how much it costs them (and all financial institutions) to borrow money. The cost of borrowing for a bank is determined by the overnight rate (i.e. the key interest rate in Canada) set by the Bank of Canada.
Are The Prime Rate and The Overnight Rate The Same Thing?
Prime rate and the overnight rate are not, in fact, the same thing, but one does directly affect the other and therefore figuring out the differences between them can be confusing.
What is The Over Night Rate?
The Bank of Canada sets its overnight rate which dictates how expensive it will be for the major financial institutions in Canada to borrow money. Then those major financial institutions set their own prime rates based on the overnight rate (as a side note, each of the 5 big banks in Canada set their own prime rate but, more often than not, it’s the same). And it’s the prime rate that affects how affordable or unaffordable it will be for you, the consumer, to borrow money. Generally speaking, the overnight rate is an indicator of how well or poorly the economy is functioning.
Simply put, the higher the Bank of Canada sets the overnight rate, the higher a bank’s prime rate will be and the higher the interest rate you’ll be offered when you go to borrow money.
How Does This Affect Me?
Your bank’s prime rate and therefore also the Bank of Canada’s overnight rate dictate just how much it will cost you to borrow. In the market to become a homeowner? You’ll definitely need a mortgage for that and the interest rate that goes along with your mortgage is based on prime rate and the overnight rate. These two factors are especially important for those who choose variable rate loans as their interest rate and therefore their cost of borrowing will fluctuate based on the outside market.
While we understand that the Bank of Canada’s overnight rate is probably not what keeps you up at night, if you’re a consumer and a borrower, and especially if you own a house, you need to be aware of the effect it will have on your life and your finances, now and ten years from now.
Check out this infographic for an in-depth look at the true cost of borrowing.
Being Prepared for a Rise in Interest Rates
So, what should you do with all this information? Prepare your finances for an increase in the cost of borrowing. In fact, the Bank of Canada just recently increased their interest rate at the beginning of September, which means it’s already a bit more expensive to borrow. For a detailed look at what you can do to prepare yourself for rising interest rates, check out our latest article (here), we’ve gone through everything you need to know and do.