Last week, we went over what is a variable rate. Today we’re going to go one step backward & explain where that variable rate comes from.
Going with a variable, you are opening up your mortgage to a lot more risk than with a fixed rate. Of course, because your rate changes throughout the year, there is no limit to how high this rate could go throughout the term. So, it’s very important for those going with a variable, to understand who or what controls Prime Rate & how they can get an idea of where their rate is going throughout the term.
Your variable, remember, is tied to the bank’s prime rate, so what determines prime rate?
Prime rate is controlled by the Bank of Canada’s overnight rate; they are directly related. 8 times per year, the Bank of Canada announces whether they will increase, decrease or leave target for the overnight rate unchanged. This is an important announcement for those with variable mortgages because this will tell you what’s going to happen to your mortgage for the next month or two.
Why would the Bank of Canada change the overnight rate, or in turn, Prime Rate?
This is really a tool the Bank of Canada uses to control inflation & the economy. When the economy is strong & the price of goods is increasing, inflation begins to happen. To try to slow down inflation, the Bank of Canada will increase this rate to get the economy under control. Higher interest rates means it’s more expensive to borrow. When it’s more expensive to borrow, you can expect less borrowing to happen, so less stimulus to the economy.
On the other hand, when the economy is slow, as we saw the Great Recession beginning 2007, the Bank of Canada wanted to encourage borrowing to ignite the economy. In this case, they lowered the target for the overnight rate to make it more attractive to borrow. Lower interest rates means it costs less to borrow. If I’ve been holding off on buying, when the government lowers that rate, it might just be enough incentive for me to take out that business loan, or buy a house, or whatever; it’s more attractive for me to borrow.
So with your variable rate mortgage, Prime Rate is not some magic number your bank uses to punish you or anything like that, it is determined by the Bank of Canada, which is basing its decision on the economy.
If you’d like to know more information on this topic or if you’d like to know where economists are predicting prime rate to go over the next 2 years, contact me.