What happens when the Bank of Canada raises or lowers interest rates?
If the economy is struggling to grow or experiencing a shock, as it did during the COVID-19 pandemic, the BoC 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 BoC 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.
How often does the Bank of Canada review interest rates?
In 2020, to help Canadians anticipate and prepare for changes in the interest rates, the BoC 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.
What is the prime rate?
Not to be confused with the BoC’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. currently at 4.70%
How is the prime rate set?
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 BoC 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.
Image and article originally from www.moneysense.ca. Read the original article here.