Ever wonder what these interest rate announcements are all about?
Just to recap, on September 5, the Bank of Canada announced that it is keeping its benchmark interest rate steady at 1.5%.
But what does this number mean? How does it impact your day-to-day life and the economy?
I’ll explain how it affects debt, the banks and the economy.
Key terms and facts
Before I dive into the details, it’s important to understand some key definitions. The media uses different terms when they talk about interest rates, which can be confusing.
Bank of Canada
As Canada’s central bank, it is the big boss of the economy. Their goal is to preserve the value of money by keeping inflation between one and three percent.
Target for the Overnight Rate (also known as the “policy interest rate”)
The Target for the Overnight Rate is the main tool used by the Bank of Canada to conduct monetary policy to try and keep inflation low and stable. A low and stable rate helps grow the economy steadily and creates jobs. The media often refers to this tool as “interest rate” in articles.
Whenever the Bank of Canada changes the policy interest rate, it affects other interest rates like mortgages and consumer loans.
The Bank has eight fixed dates every year where they announce whether or not it will change the rate. The next announcement will be on October 24, 2018.
Before I get into how changing interest rates affect you, it’s helpful to understand how it impacts the banks. While they may be fierce competitors, they actually borrow and lend money to each other all the time!
After all of the lending activities, customer withdrawal and deposits, a bank may have a shortage or surplus of cash at the end of the business day.
The banks with extra cash often lend money overnight to banks that have a shortage. The borrower must pay back the money and interest at the start of business the next day. These exchanges help the banking system remain stable and liquid.
This is the interest rate charged on the loans banks make to each other in the overnight market. The Bank of Canada can intervene in the overnight market at the target rate if the market rate is moving away from the target.
Why does the Bank of Canada increase and decrease interest rates?
The higher the policy interest rate is, the more expensive it is to borrow money. When interest rates go down, people and businesses are encouraged to borrow and spend more which boosts the economy.
But if the economy grows too fast, it can lead to rising inflation and hurt Canadians like having high levels of household debt and inflated housing prices. The Bank will then raise interest rates to slow down borrowing and spending. This puts a brake on inflation to stabilize housing costs and reduce debt.
The Bank made a 0.25% increase in July and has hiked it a total of four times since mid-2017.
But what about me? How do the interest rates affect my mortgage and other debts?
An increase in the policy interest rate doesn’t affect people who have fixed rate mortgages.
But a rake hike could lead to an increase in variable interest rates resulting in people paying more each month. Mortgages, lines of credit, car loans, student loans and credit cards may have variable rates.
Let’s say you had a variable rate mortgage in the amount of $400,000 amortized over 25 years. If your mortgage rate is 2.35%, then your monthly mortgage payment would be $1,762.
But if the prime rate were to go up by just 0.25%, your mortgage rate suddenly increases to 2.60%, and your monthly mortgage payment goes up to $1,812. It may not look like much, but it definitely adds up over time.
More on the Overnight Target Rate
Here are a few articles if you want to know more about policy interest rates:
• Bank of Canada holds key interest rate steady at 1.5%
• Bank of Canada holds rate steady for now as NAFTA uncertainty weighs
• Target for the Overnight Rate
It’s always been important for me to explain important aspects of the real estate industry to the people and make sure they understand relevant news in today’s market.
Let me know if you have any questions about interest rates or anything else about real estate.