Prime Lending Rate or “Prime Rate” in Canada
What is the Prime Lending Rate?
In Canada, the prime lending rate is a guideline interest rate used by banks on loans for their most creditworthy, best, or “prime” clients. The prime rate rises and falls with the ebb and flow of the Canadian economy, influenced significantly by the overnight rate. This rate is set by the Bank of Canada.
The prime rate is of particular significance to variable rate mortgages. These are mortgages that use a rate that tracks the prime and changes in lock-step with it over the term of the mortgage. Because of this, variable rate mortgages are less insulated from economic fluctuations than their fixed-rate mortgage counterparts.
The Prime Rate & Variable Rate Loans
Generally speaking, the prime rate is rarely added to variable rate loans. Variable rate loans track the prime rate using an adjustment value. That value will get added to or subtracted from the prime rate. If the value adjustment winds up subtracting from the prime rate, this is known as sub–prime lending.
When prime lending rates were high, many Canadian lenders were offering variable rate mortgages as low as prime minus 0.90 per cent. Since then, economic pressures and shrinking profit margins have forced banks and lenders to decrease prime rate adjustments. These adjustments have shifted to anywhere between prime minus 0.21 to prime plus 0.20 per cent.
What influences the prime rate?
The key overnight rate primarily influences the prime rate. The Bank of Canada sets this on only eight pre-announced days per year. Based on economic pressures, the bank then sets the overnight rate.
The Bank of Canada’s monetary policy manipulates the overnight rate in a way that balances its long-term goal of avoiding inflation. It does this against short-term economic goals like reducing the unemployment rate.
Historically, the prime rate has been somewhere around 200 basis points (2%) higher than the target overnight rate. When the Bank of Canada increases or decreases its target overnight rate, the big five banks typically follow suit. There have been occasions where the banks don’t immediately change their prime rates. Some Canadian banks have had different prime rates from others.
How changes in the prime rate affect consumers
Businesses, families, and individuals alike cannot avoid credit products. All of these are affected by either the prime rate, or at a deeper level, overnight rates.
Even without having a loan yourself, it’s highly likely that you’re dealing with a business or person that does. Perhaps you have a credit card. Maybe you buy your fuel at a gas bar that hasn’t paid off their commercial mortgage yet. Perhaps the company you work for has a line of credit. Maybe the guys behind the website you’re currently visiting have an emergency line of credit.
One way or another, the effects of changes in these interest rates manifest themselves in your day-to-day life. A higher prime rate might cause that gas bar you visit to charge a few cents more on the litre.
It’s safe to assume that someone who was responsible for making a component for the computer you’re currently using manufactured their part on borrowed funds. And that increased the cost of your computer.
How the prime rate influences the mortgage market in Canada
In the Canadian mortgage market, the prime rate helps calculate lending money on variable rate or line of credit mortgages.
A variable rate is typically a closed term, either 3 or 5 years in length. The rate depends on the economy and availability of mortgage money during a particular cycle. Variable rate mortgages will follow prime rate less a set discount. For example: Some variable rates will have a Prime Rate minus 0.85%. Today, the prime rate is set at 2.95% and the best variable rate is 2.85%
A line of credit is typically based on prime rate plus a percentage or basis point count. A line of credit in Canada is a very popular form of borrowing and they all follow the prime rate lending model. This means little variance from institution to institution.
Regardless of whether it’s a variable mortgage or a line of credit, they are both heavily based on and follow the prime rate in Canada. When the prime rate changes, so can the variable rate or line of credit interest calculation used for your loan.
Having an understanding of the prime rate and how it is tied to our monetary system and the Canadian economy is important. This makes things easier when it comes to deciding what options you choose when borrowing money.
A History of the Prime Rate in Canada
Prime Rate Historical Graph
!! — Prime rate graph — !!