By Julie Jaggernath
Do you tune out when the news mentions interest rate increases or changes by the Bank of Canada? You’re not alone. Average Canadians find it hard to see why Bank of Canada interest rate announcements matter to them. This has a lot to do with the fact that most people have no idea what the Bank of Canada is, its role in the Canadian economy, and what the announcements mean. However, interest rate announcements affect each of us in many ways, so here is a simple explanation of what you need to know.
Click to jump down to the section that interests you most:
- What is the role of the Bank of Canada?
- Why does the Bank of Canada raise interest rates?
- Two ways the Bank of Canada is different than your bank.
- Variable vs fixed rates, are all affected by the Bank of Canada?
- How big a deal can a quarter point rate increase really be? Mortgage payment example.
- How else could you be impacted when interest rates go up?
- Is there any way I can protect myself from rising interest rates?
The Bank of Canada (BoC) is a central bank, in fact, “central bank” is another name for the BoC. Very basically, the role of the Bank of Canada is to take measures to protect the Canadian economy. What affects and governs economic factors is extremely complex, and there’s no perfect formula to get it right for everyone. For instance, when mortgage rates are really low, this helps younger people buy a first home. However, it also means that savings accounts pay less interest. Someone within the 10-15 year window before retirement, or a senior living off their savings, low interest rates mean they have less money to spend on what they need and want.
How Does the Bank of Canada Protect the Economy?
The Bank of Canada works to keep the inflation rate low. Keeping inflation in check protects the economy and our jobs. This allows us to manage our family’s needs, take care of our business, and make savings and investment decisions.
Inflation is the increase in the cost of goods and services, and is caused by the interplay of a number of economic factors. It is a sustained increase that continues year after year, not just a temporary spike in prices. When inflation gets too high, goods and services become unaffordable and consumers stop spending money. This has drastic consequences on an economy and countries all around the world do what they can to avoid creating circumstances where consumers are afraid to spend their money.
The Bank of Canada will raise interest rates in an effort to reduce how much Canadians spend and how much personal debt we take on. This stabilizes housing costs because the more interest we have to pay when we borrow money, the less we can borrow.
You might wonder why the BoC would want us to borrow less. The economy is good right now, we have recovered from the economic downturn from a decade ago, and there are no signs of a recession. Why not encourage Canadians to borrow more when credit is cheap? It turns out that if you don’t want to look out for your own future, the BoC will try and do it for you because the low rates we’ve all become comfortable with started increasing in 2017 and as of now (June 2018), there’s no indication that trend will reverse.
The central bank wants to protect Canada and Canadians from economic upheaval. Encouraging us not to borrow more than we can comfortably afford is extremely important for a healthy and stable economy.
There are 2 key ways the BoC is different than our day-to-day banks. Firstly, the Bank of Canada is known as the banker’s bank. You might not think of your bank needing a bank, but every business needs a bank. Our banks are businesses and need ways to borrow and invest just like we do. They must qualify to borrow money in much the same way average Canadians must qualify when we want to take out a loan or mortgage (you might have heard that banks have credit ratings). The banks borrow from the BoC, that’s why it’s called the central bank.
A second very important difference is that the rate at which the Bank of Canada lends money to other banks and major financial institutions (called the overnight rate), this determines the rates our banks charge us when we want to borrow money. Our bank sets its Prime lending rate based on the Bank of Canada’s overnight rate. It is precisely this difference that makes headlines each time the central bank makes a rate announcement.
When the central bank changes how much it charges our banks to borrow money, our banks adjust the rates they charge us. Variable rate loans, lines of credit, and mortgages are the most affected credit products when interest rates change due to a BoC announcement.
For example, if you are being charged Prime plus 3% on your line of credit, or Prime minus 0.25% on your mortgage, this affects how much interest you pay your lender. It can also affect your payment amount if you lowered your payment to the interest rate you are being charged. Some people do this for affordability reasons but by making slightly higher payments, you protect yourself against interest rate fluctuations.
Fixed rate loans and mortgages can be affected as well, but the way that happens is not as straight forward as it is with variable rate products. Bank of Canada interest rate changes don’t usually affect the interest rates on credit cards, but it could happen once there are many increases over a period of time. Financial institutions can also change their rates at any time, independent of a Bank of Canada rate announcement.
A quarter point is another way of saying 0.25% ( ¼ per cent), and a single quarter point rate hike on its own might not be a big deal. The additional money you pay in interest, however, over a 20 – 25 year mortgage can add up to tens of thousands of dollars. And a quarter point rate hike typically comes with other quarter point rate hikes. Very quickly these rate hikes can add up until you possibly realize one day that your line of credit is costing you 1.5% more than it did when you took it out a few years ago. A whole percentage point or more is definitely a big deal.
Mortgage Payment Example
For example, with a $500,000 mortgage, amortized over 25 years with an interest rate of 3.45% (the current Prime rate at most financial institutions), the monthly payment would be $2,494. If the rate increases to 4.45%, the monthly payment increases to $2,753, a difference of $259 every month. However, to qualify for this mortgage, your budget must be able to afford a payment based on the current 5-year conventional rate with is posted at 5.34% right now. At 5.34% your payment would be $3,006, or $512 higher than at 3.45%. (Try out a mortgage payment calculator to see how much your mortgage would change with even a small interest rate adjustment.)
Where would the extra $250 - $500 come from each month? Think about how your lifestyle would change with less money to spend on other expenses. Would you have to increase your income? Maybe decrease other expenses? These are serious considerations for anyone already living pay cheque to pay cheque, but a combination would likely turn out best.
Could there be more potentially bad news? Unfortunately, yes. If rates go up and your budget gets so tight that you start falling behind with your payments, your lenders will impose any number of consequences on you. For instance, when you miss payments, on many credit cards that now triggers an automatic 5% APR (annual percentage rate) increase. It will then take 12 months of making all of your payments in full and on time to get the 5% penalty removed.
If during that year you are only able to make your minimum payments, you could be putting your credit score in jeopardy despite doing the minimum of what is required of you. A credit score reflects how you manage your existing credit products and only making minimum payments for an extended period of time signals cash flow problems. A decreased credit score will impact your ability to renew and/or renegotiate your mortgage at the most attractive interest rates. It will impact your ability to qualify for a car loan or lease at 0% financing (which is reserved for only the best customers). Your line of credit will likely see a rate increase because the lender is trying to lessen their potential risk if you default on your payments entirely.
The Bank of Canada makes its decisions based on how Canada’s economy performs, but we never know exactly what will happen because Canada’s economy is also heavily influenced by external factors, e.g. the economy south of the border. The official announcements are made approximately every 6 weeks and the key interest rate can go up, down, or stay the same; we never know for sure ahead of time what will happen. All of this uncertainty means that the best way to protect ourselves is to live within our means - only borrow what we can comfortably afford to repay, save for emergencies, and plan for the future. By not spreading ourselves too thin and avoiding getting deep into debt we can remain in control of our choices and lifestyle. That is how you can protect yourself financially, regardless of any interest rate changes the central bank makes.