The Prime Rate: The Compass of Variable Rates in Canada
For any borrower holding a variable-rate mortgage or a home equity line of credit in Canada, the prime rate is the most important number to watch. This benchmark rate, set by each financial institution, directly determines the borrowing cost of variable-rate products and fluctuates based on the Bank of Canada's monetary policy decisions.
How Is the Prime Rate Determined?
The prime rate is established by each Canadian bank independently, but it closely tracks the Bank of Canada's policy rate (the overnight target rate). When the Bank of Canada announces a change to its policy rate, major banks adjust their prime rate within the following days, generally by the same amount. The historical spread between the policy rate and the prime rate is approximately 2.20%, although this spread has varied slightly over time.
- Prime rate
- The benchmark interest rate set by each Canadian financial institution, serving as the basis for calculating rates on variable-rate loans, lines of credit, and HELOCs. It closely follows the Bank of Canada's policy rate and historically sits approximately 2.20% above it.
The Bank of Canada and the Rate Cycle
The Bank of Canada adjusts its policy rate eight times per year on fixed announcement dates. These decisions are based on inflation, economic growth, and overall financial conditions. During periods of high inflation, the Bank raises its policy rate to slow the economy. During recessions or slowdowns, it lowers the rate to stimulate borrowing and investment. Each change directly impacts the prime rate and, consequently, the rate paid by variable-rate mortgage holders.
Impact on Variable-Rate Mortgages
- Adjustable payment: the monthly payment amount changes with each prime rate variation. If the rate rises by 0.25%, the payment increases immediately to reflect the new rate.
- Fixed payment with variable rate: the monthly payment amount remains constant, but the split between principal and interest changes. When the rate rises, a greater share of the payment goes to interest and less to principal, slowing the mortgage paydown.
- Trigger rate: when the prime rate rises enough, the fixed payment may no longer cover the interest. The lender may then require a payment increase or a partial balance repayment.
- Home equity line of credit (HELOC): the HELOC rate is directly tied to the prime rate, typically prime plus 0.50% to 1.00%. Changes are immédiate and affect the minimum monthly interest payment.
How to Protect Yourself Against Prime Rate Increases
- Understand the stress test: OSFI requires borrowers to qualify at the contractual rate plus 2% or the floor qualifying rate, whichever is higher. This safety cushion means your budget should be able to absorb a significant prime rate increase.
- Know your conversion option: Most variable-rate mortgages include an option to convert to a fixed rate without penalty. If rates rise rapidly and your risk tolerance is reached, you can lock in a fixed rate for the remainder of the term.
- Monitor Bank of Canada announcements: Eight times per year, the Bank of Canada announces its policy rate decision. Follow these announcements and discuss their potential impact on your mortgage with your AMF broker.
- Maintain a budget cushion: Plan for the possibility of a 1% to 2% increase in your mortgage rate within your budget. This cushion will prevent financial stress if rates rise beyond your expectations.