You’ve probably heard about the overnight lending rate and prime rate in the news. However, you may not be entirely sure what they are and how they affect things like inflation or even mortgage rates. So, let’s start with the basics!
What’s the Overnight Lending Rate?
Have you ever heard the terms “Policy Rate” or “Overnight Lending Rate”? This is the Bank of Canada’s central interest rate used to keep the economy on track. This is also the rate that financial institutions (FIs) use to borrow funds from one another. The primary objective of this rate is to control inflation (more on that in a bit!). The increase or decrease of this rate starts the ripple effect of rate changes throughout the economy including both deposit and loan rates.
What’s Prime Rate?
It’s usually the starting point an FI uses when setting the interest rates for all its lending and credit products such as mortgages, lines of credits and loans. The Prime Rate will usually increase or decrease in accordance with the changes to the Policy Rate.
How does inflation fit in?
The Bank of Canada’s main objective is to manage inflation in the Canadian economy, with an ideal range between 1% and 3%. The Policy Rate or Overnight Lending Rate is the primary tool used to counter inflation. This is because interest rates generally move opposite to the rate of inflation. But why?
Here’s the scoop:
- Higher interest rates mean borrowing is more expensive which generally lowers spending and therefore causes slower inflation (price increases).
- When the Bank of Canada lowers the Policy Rate, the reverse is true. They want to stimulate the economy by making borrowing cheaper which can drive up the price of goods and services (inflation).
In summary, economic activity is cyclical. As rates go down, demand will increase for goods and services causing a gradual increase in prices (inflation). When inflation is too high, rates must increase to curb the demand for goods and services, which in turn will lead to a decrease in the rate of inflation.
It’s important to note that there are many factors to consider and the above is a generalized approach to thinking about the relationship between interest rates and inflation.
How this affects you!
As we said above, when the Bank of Canada changes its Policy Rate to manage inflation, it’s the beginning of the ripple effect of rate changes throughout the economy that affect both deposit and loan rates for consumers like you.
FIs use the Prime Rate to set their consumer lending rates. You’ll usually see variable loans set at a rate of Prime +. Basically, the higher the risk to the FI, the higher the rate to the consumer.
Both fixed and variable mortgage rates are usually set below Prime Rate and that’s because mortgages are usually the safest type of loan. This is because a value of a mortgage loan is secured against the value of the home, making the loan a lot less risky.
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Making informed decisions
Understanding the relationship between inflation, Prime Rate and mortgage rates can help you make better financial decisions. Knowing how these rates are set and what influences them can guide you in choosing the best loan and mortgage options.
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