How the Bank of Canada Rate Changes Affect Your Mortgage
You may have been hearing about the Bank of Canada’s rate changes in the news lately. As a future or current property owner, it’s always important to understand how the Bank of Canada rate changes affect your mortgage.
COVID-19 has been having distressing updates in the news recently and a significant consequence has been the impact on the economy. To try and offset some of this, the Bank of Canada has decreased it’s interest rate.
In general, a decrease in the Bank of Canada’s interest rates translates into a decrease in mortgage rates for you. However, it seems due to the unique set of circumstances surrounding the change, the savings haven’t been felt everywhere. Experts have been attributing this to banks increasing their margins as a way to protect themselves during these uncertain times. It’s also being considered as an issue of liquidity, as banks want to ensure they can continue lending to consumers and businesses during this time.
Regardless, you may already be experiencing the impact of rate changes or will do so in the near future as the situation evolves quickly. You may be asking yourself what it means and how it impacts you. In this article, we’ll break down the key concepts behind the change and how it’s going to affect you, a homeowner or future homeowner.
Who and Where is the Bank of Canada
The Bank of Canada is Canada’s central bank, headquartered in Ottawa. Its job is to “promote the economic and financial welfare of Canada“. One of its main responsibilities is to keep inflation low, stable and at the inflation-control target, which is set between 1% and 3%.
What Does the Bank of Canada Do?
The way the Bank of Canada does this is through adjusting its key policy rate, aka overnight rate. The key policy rate is the rate that it expects financial institutions, like banks, will use for overnight loans between each other. Overnight loans are made to ensure there is enough liquidity to meet daily demands.
The key policy rate is the midpoint of a .5%-wide range, with the lower point known as the deposit rate and the upper point known as the Bank Rate. For example, if the range is 2 to 2.5%, the key policy rate would be 2.25%. 2% would be the deposit rate and 2.5% would be the bank rate.
This key policy rate is then used by the banks to determine the prime rate. The prime rate is the basis of determining what rate to charge you.
Your interest rate (what you are charged) is generally a percentage added to the prime rate. A common example you may have heard of is an interest rate for loans set at prime + 4%.
If the key policy rate increases, it becomes more expensive for banks to borrow from each other, so they have to increase the prime rate to cover their costs. This, in turn, will affect your interest rate.
Why Does the Bank of Canada Adjust Rates?
If inflation is increasing too quickly, the Bank of Canada increases the key policy rate. In turn, financial institutions will increase interest rates on lending products. This discourages borrowing. If you can borrow less money, you’ll spend less. This stymies the increase in prices, which is leading the inflation above target levels.
If inflation is below target levels, the Bank of Canada will decrease the key policy rate. This means the Bank of Canada is trying to encourage spending and stimulate the economy. Lower interest rates = more loans = more money to spend, which puts upward pressure on prices and therefore, inflation. In a nutshell, that’s the general idea behind the rate set by the Bank of Canada.
When Does the Bank of Canada Announce Rates?
Interest rate announcements are generally made 8 times a year. You can keep a look out for them here.
In addition to the critical health consequences, COVID-19, coupled with the decline in world oil prices, is having a serious effect on the economy. This has caused the Bank of Canada to make unscheduled cuts to the key policy rate. After the change on March 4th, the next one was scheduled for April 15th. However, thus far, the rate has been changed on March 16th and 27th. At the time of this article’s publication, the rate is now at .25%.
How the Bank of Canada Rate Changes Affect Your Mortgage
An increase in the key policy interest rate may mean an increase in your mortgage rate. Correspondingly, a decrease in the key policy interest rate may mean a decrease in your mortgage rate. The type of mortgage you have will be a factor when considering the effect on your monthly cash flow:
Variable mortgage: Your rate is based on the key policy rate of the Bank of Canada. When the Bank of Canada adjusts this rate, your rate will change and you’ll feel the effects quickly.
Fixed mortgage: In this case, your rate is tied to the interest rate of Canada Bonds. If the key policy interest rate increases, this will also increase the interest rate of bonds. When its time for your to renew your mortgage, banks will take the interest rate of bonds, add a “mark-up” (officially known as a spread) to cover costs and make a profit. That’s the rate you’ll be charged. However, your rate won’t change until its time to renew your mortgage.
If the rate goes up, the first question to ask is whether you can still afford the monthly payments? An increase in rates will mean an increase in money flowing out of your pocket every month.
Apart from your monthly cash flow, there are 3 common scenarios where you need to consider the impact on your property:
1. Do you have a mortgage renewal coming up?
2. Are you planning to buy a property soon?
3. Are you selling?
Your Mortgage Renewal Is Coming Up
In the rate is going up, consider whether you should increase the amortization period (the period over which you pay) to balance out the higher interest rate and reduce your monthly payments.
You can also consider whether a lump sum payment can be made to your mortgage to lower the regular payments.
Finally, when you’re deciding on the type of mortgage, look for projections on the economy and interest rates over a period of 5 years. If the economy is in a recession and it’s expected to last for few years, you should do you research to determine how this will affect interest rates.
You’re Planning to Buy a Property
If you’re planning an upcoming purchase and the rate is forecasted to go up, accelerate your purchase or try to lock in a mortgage rate.
If you’re going to be paying lower monthly payments than planned due to a decrease in interest rates, you might be tempted to consider a higher priced property; the rate change seems to increase your purchasing power. However, you also need to consider the effect on your finances when/if the rates are forecasted to increase – your monthly payments will increase as well.
You’re Planning to Sell Your Property
If you have a fixed mortgage and you’re planning to sell your property before your term comes to an end, consider the interest rate you’re paying versus the market rate.
If the market rate is lower and you sell before the end of you term, you will likely have to pay a heavy penalty to your lender to cancel your mortgage However, if it went up, you have more leverage with your lender to release you from the mortgage. In addition, you can also pitch the mortgage transfer to potential buyers as part of the sale.
The Numbers for How the Bank of Canada Rate Changes Affect Your Mortgage
Now, let’s look at a case study to see how change in rates could impact your monthly cash flow. The Bank of Canada raises its policy rate from 1.50 to 1.75. That is an increase of 25 basis points (.25%). Subsequently, banks have to decide how that will affect their Prime Rate, which variable rates are based on. In our scenario, let’s say the Prime rate is changed by the same amount (which is what usually happens) of .25%.
If we want to see a potential financial impact, let’s look at Denise’s situation. She purchased a 500K house with a 5% downpayment, a 25-year amortization period and a rate of 3% on a fixed mortgage.
After 5 years, Denise has a renewal coming up. With the change, her rate has now gone to 3.25%. We can calculate the impact using Ratehub. For Denise, this comes up to about $50 a month, $600 dollars a year and $3,000 over 5 years. But remember that this is based on her circumstances and a .25% change in the mortgage rate.
Depending on your set of circumstances, you may be able to absorb the extra costs. However, it’s something to think about well before the Bank of Canada headlines pop up, whether you’re looking to buy or just working on your monthly budget.