What is the prime rate?
The prime rate as of March 14, 2024 is 7.20%
The prime rate is most commonly defined as the interest rate commercial banks charge their most credit-worthy customers. It serves as a benchmark rate for setting the rates on a variety of financial products, including mortgages, personal loans, and lines of credit. The prime rate is influenced by a number of factors, including inflation, economic growth, and the supply and demand for credit.
The prime rate is determined by the banks themselves, and it is typically set at a level that is 1.5 to 2.5 percentage points above the overnight lending rate set by the Bank of Canada. The prime rate is currently (as of Mar 14, 2024) 7.20%, the highest it has been in over twenty years.
The current prime rate appears high to us today, partly due to the fact that is has been unusually low over the past decade. The average Prime Rate over the past 50 years is 7.23%, comparable to today. However, the average over the past 20 years is 3.75%. Compared to more recent history, the prime rate is high at 7.20%.
How is the prime rate determined?
The Bank of Canada's monetary policy is a key determinant of the prime rate even though it does not directly set the rate. The Bank of Canada uses its benchmark overnight lending rate to regulate the nation's economic growth and restrain inflation. The Bank of Canada influences short-term interest rates by adjusting the target for the overnight rate on eight fixed dates each year.
When the Bank of Canada changes the overnight rate, the Canadian banks usually change their prime rates within a couple days. They tend to move their prime rates by the same amount and in the same direction that the Bank of Canada moves the overnight lending rate.
How do banks use the prime rate?
Banks use the prime rate as a benchmark rate for a variety of financial products, including mortgages, personal loans, and lines of credit. The interest rate charged for these products is typically set at a margin above or below the prime rate. Most products will have a rate of Prime plus a margin but variable-rate mortgages for the best borrowers are usually priced at Prime minus a margin. For example, a bank might offer a variable-rate mortgage at a rate of prime minus 1% (equal to 6.20% today). As the Prime Rate moves up or down, the variable mortgage rate will move also, but the margin stays the same for the term of the mortgage.
How are variable mortgage rates set relative to the prime rate?
Variable rate mortgages are directly tied to the prime rate. When the prime rate goes up, so does the interest rate on a variable rate mortgage. Conversely, when the prime rate goes down, so does the interest rate on a variable rate mortgage. This means that borrowers with variable rate mortgages are exposed to interest rate risk, as the cost of their mortgage will increase if the prime rate increases.
The margin relative to the prime rate depends on market conditions, the risk profile of the borrower and the costs of lending. When market conditions are positive, the margin for the best borrowers can be as much as minus 1.50%. When market conditions worsen, that margin can be as small as 0.25% to 0.50%.
The prime rate is usually the same for all banks. They will use their prime rate for pricing variable rate mortgages and the competitive difference in rate between the banks is the margin below the prime rate that they offer. However, there is one bank that does things differently. TD Bank uses a prime rate for mortgage lending that is equal to their prime rate plus 0.15%. They have been doing this since 2016. Borrowers should note this since TD needs to offer a larger margin discount to their prime rate to get you to the same rate being offered by other lenders.
What is the historic margin between variable mortgage rates and the Prime Rate?
The historic margin between variable mortgage rates and the prime rate has varied over time. In general, the margin tends to be a discount ranging between 0.25% and 1.5%, depending on market conditions and the risk profile of the borrower. During times of economic uncertainty or when credit conditions are tight, banks may offer less of a discount margin to account for increased risk.
For those of you that are looking to get a Heloc, you should note that the rate for a Heloc will be higher than for a variable-rate mortgage. Helocs carry an interest rate that is usually prime plus a margin. This margin can range between 0.50% and 3.0% at the banks.
Can anyone predict where the prime rate will go in the future?
Predicting where the prime rate will go in the future is difficult. It is influenced by a wide range of factors and, as we saw in 2022, can be subject to sudden changes. Some economists and analysts use models to make forecasts projecting the future direction of interest rates, but these projections are often imprecise and subject to error. Ultimately, the direction of the prime rate will depend on a variety of economic factors that influence the rate setting policy of the Bank of Canada, including inflation, economic growth, and the supply and demand for credit.
Conclusion
The Canadian bank prime rate plays an important role in the country's financial system, serving as a benchmark rate for a variety of financial products. While the Bank of Canada does not directly set the prime rate, it does have an indirect influence on it through its monetary policy. Banks use the prime rate as a basis for setting interest rates on loans and lines of credit, and borrowers with these variable-rate products, such as variable-rate mortgages, are exposed to interest rate risk. While predicting the future direction of the prime rate is difficult, understanding how it is determined and how it is used by banks and borrowers can help individuals make informed financial decisions.
If you have a variable rate mortgage you need to be aware that rates may continue to increase. However, market expectations are that rates will come down in 2024. This does appear likely but be careful not to put too much weight on these predictions. They have been wrong in the recent past. If you are risk-averse, manage your own affairs without trying to guess where rates are going. Variable-rate mortgages contain risk and are not for everyone. If you are certain in your belief that rates are coming down then a variable-rate mortgage might make sense, but understand that variable rates are materially higher than fixed rates today so that rate decline needs to be significant for you to benefit.
If you are in the market currently for a mortgage, a fixed rate might be the best solution. Perhaps even a short-term fixed-rate mortgage. With no exposure to interest rate risk during the term of the mortgage, a fixed-rate mortgage is the conservative choice for the majority of us that have a low risk tolerance.
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