The prime interest rate, often referred to simply as the “prime rate,” is the annual interest rate that major Canadian banks and financial institutions use as a benchmark for setting interest rates on different loan products. These products include variable-rate mortgages, personal loans, and home equity lines of credit (HELOCs). For example, the interest you pay on a variable-rate mortgage is sometimes determined by taking the prime rate and subtracting a specific percentage. The prime rate in Canada is 5.45% as of January 4, 2025.

The Process Behind Setting the Prime Rate in Canada

The Process Behind Setting the Prime Rate in Canada
Credits : Global News

The interest rate that banks charge their most reliable clients is known as the prime rate in Canada. It is closely related to the overnight rate target set by the Bank of Canada, which is often referred to as the policy interest rate or key interest rate. Financial institutions usually follow suit by modifying their prime rates in accordance with changes made by the Bank of Canada. Below is how the procedure operates:

    • Bank of Canada’s Overnight Rate: The Bank of Canada sets the overnight rate to achieve its monetary policy goals, primarily to keep inflation low, stable, and predictable. This rate influences the cost of borrowing for financial institutions.
    • Adjustment by Financial Institutions: After the Bank of Canada changes the overnight rate, major banks usually adjust their prime rates by the same amount. For example, if the Bank of Canada raises the overnight rate by 0.25%, banks are likely to increase their prime rates by 0.25% as well.
    • Application to Consumer Loans: The prime rate is a benchmark for various lending products, including variable-rate mortgages, lines of credit, and personal loans. Changes in the prime rate directly affect the interest rates on these products.

The Impact of the Prime Rate on Variable Mortgages in Canada

The Impact of the Prime Rate on Variable Mortgages in Canada
Credits : nerdwallet

The prime rate in Canada plays a key role in determining variable mortgage rates. To determine their prime rate, banks generally add around 2.20% to the policy interest rate set by the Bank of Canada (BoC). For lenders, this prime rate acts as a benchmark. Your interest rate is directly influenced by the prime rate if you have a variable-rate mortgage. These mortgages are offered by lenders at rates that are either “prime plus” or “prime minus”, a specific percentage. Your mortgage rate, for example, may be “prime minus 0.5%.” This means that your mortgage rate will be impacted right away by any changes in the prime rate.

When the prime rate goes up, the interest rate on variable mortgages also rises. This leads to higher monthly payments. On the other hand, when the prime rate drops, your mortgage payments go down as the interest rate decreases. The calculation of fixed prime mortgage rates in Canada differs from that of variable mortgage rates. Bond rates and market expectations have a greater impact on them than the prime rate. Understanding this connection helps borrowers anticipate changes in their mortgage payments. Your mortgage decision-making can be improved by keeping an eye on the Bank of Canada’s declarations and economic developments.

Prime Rate’s Indirect Effect on Fixed Mortgages

In Canada, fixed mortgage rates are not directly tied to the prime rate. Instead, they are influenced by the bond market, specifically the yields on Government of Canada bonds. Banks and lenders use these bond yields as a guide when setting fixed mortgage rates. If bond yields go up, fixed rates usually rise, and if bond yields drop, fixed rates tend to fall. Although the prime rate doesn’t directly set fixed mortgage rates, it can have an indirect impact. The prime rate is based on the Bank of Canada’s policy rate, which reflects the central bank’s outlook on the economy and inflation. When the Bank of Canada adjusts its policy rate, it can shift economic expectations. This, in turn, affects bond yields, which can influence fixed mortgage rates.

In simple terms, fixed mortgage rates depend more on the bond market than the prime rate. However, changes in the prime rate can still affect fixed rates indirectly over time through broader economic trends. Understanding this relationship can help borrowers make more informed decisions when choosing between fixed and variable mortgages.

How Does Prime Rate Connect to the Bank of Canada’s Overnight Rate?

The prime rate in Canada is closely linked to the Bank of Canada’s overnight rate. The overnight rate is the interest rate at which financial institutions borrow and lend one-day (overnight) funds among themselves. The Bank of Canada sets a target for this rate as part of its monetary policy to control inflation and stabilise the economy. Financial institutions usually modify their prime rates in response to changes in the Bank of Canada’s overnight rate. If the overnight rate is hiked, for instance, banks may boost their prime rates to compensate for the greater cost of borrowing. Conversely, if the overnight rate is lowered, banks may cut their prime rates, which would make loans and mortgages more affordable to consumers.

This relationship means that the prime rate directly affects interest rates for various consumer loans and mortgages. It is influenced by the Bank of Canada’s monetary policy decisions regarding the overnight rate. Understanding this connection can help consumers anticipate changes in borrowing costs based on the central bank’s policy announcements.

Canada’s Prime Rate Through the Decades

The history of prime rates in Canada is deeply tied to the Bank of Canada’s (BoC) monetary policies, as the prime rate is influenced by the BoC’s target overnight rate. This history reflects Canada’s economic evolution, highlighting how interest rates have been used to address inflation, economic crises, and growth objectives.

1935 – 1955: The Formation of the Bank of Canada and Post-War Stability

The Bank of Canada was established in 1935 during the Great Depression to stabilise the Canadian economy. During this period, the Bank set the target overnight rate, which indirectly influenced prime rates. Initially, the rate was set at 2.5% in 1935 and later reduced to 1.5% by 1945 to support recovery efforts following World War II. By 1955, the rate had stabilised at 2.0%, reflecting a relatively steady and recovering economic environment.

1977 – 1991: Global Oil Crisis and Record Highs

The 1970s and 1980s were characterised by oil price shocks and soaring inflation, largely driven by the OPEC oil embargo. In 1981, the target overnight rate reached an unprecedented high of 20.03%, resulting in record-high prime rates. These elevated rates were implemented to combat inflation but also led to significant economic challenges, including slowed growth. By 1987, the overnight rate had dropped to 7.14%, providing some relief and easing borrowing conditions.

1991 – 2008: Inflation Targeting and Stability

The introduction of inflation targeting in 1991 marked a transformative shift in monetary policy. The Bank of Canada aimed to maintain inflation at around 2%, which brought greater predictability to prime rates. During this period, the prime rate steadily declined, reflecting a strong focus on economic stability and growth. Compared to earlier decades, fluctuations were minimal, underscoring the success of this approach in stabilising the economy.

2009 – 2017: Financial Crisis and Oil Price Collapse

After the 2008 global financial crisis, the Bank of Canada lowered the overnight rate to historically low levels to help boost the economy. As a result, the prime rate fell below 3%. In 2014, a sharp drop in global oil prices created economic challenges for Canada, but the prime rate stayed low. It briefly rose to 3% before falling back to around 2.7%, keeping borrowing costs affordable during this turbulent period.

2018 – 2022: COVID-19 Pandemic and Economic Uncertainty

Before the COVID-19 pandemic, Canada experienced steady economic growth, but inflation in 2019 kept the prime rate at a maximum of 3.95%. During the pandemic, the Bank of Canada reduced the overnight rate to 0.25%, which led to the prime rate dropping to a historic low of 2.45%. This significant reduction was aimed at supporting borrowing and spending during an exceptionally challenging time for the economy.

2022 – Present: Addressing Inflation

As inflation surged in 2022, the Bank of Canada increased the overnight rate from 0.25% to 4.25% by the end of the year, driving the prime rate above 6%. By 2023, with inflation still above target levels, the prime rate rose further to over 7%. These rate hikes were part of the Bank’s ongoing efforts to control inflation and restore stability to the economy.

Conclusion

The prime interest rate in Canada is a cornerstone of the nation’s financial landscape, intricately tied to the Bank of Canada’s monetary policy. Over the decades, it has played a critical role in addressing economic challenges, from stabilising the economy during the Great Depression to combating inflation in the 1980s and responding to crises such as the 2008 financial downturn and the COVID-19 pandemic. Understanding the prime rate’s relationship with the Bank of Canada’s overnight rate, as well as its impact on lending products and mortgages, equips consumers and businesses to make informed financial decisions. Whether navigating periods of economic stability or uncertainty, the prime rate reflects broader monetary trends and remains a key tool for achieving financial equilibrium in Canada.

Frequently Asked Questions (FAQs)

What is the prime interest rate in Canada?

The prime interest rate in Canada is the annual benchmark interest rate that major banks use to determine interest rates for various lending products, such as variable-rate mortgages and personal loans. As of January 4, 2025, the prime rate in Canada is 5.45%.

What is the price of Prime in Canada?

What is the new Canada interest rate?

The Bank of Canada's overnight rate, which influences the prime interest rate, was 4.25% as of the most recent update. This rate serves as a key driver for the prime rate, which financial institutions adjust in response to changes in the overnight rate.