In a previous post, we looked at the relationship between the prime rate and savings account interest rates. But what about the linkage between the prime rate and GIC rates?
Turns out, they’re quite similar. More on that later. But first, some background.
What’s the prime rate?
You may be familiar with the prime rate or at least have heard it mentioned. So, what exactly is it? The prime rate is the interest rate at which banks lend to their best clients. Their best clients are typically those deemed the most creditworthy (and it probably doesn’t hurt to be a large client, either). For this reason, other loans are usually expressed as a function of prime. If prime is 2% and a bank will lend you money at 2.5%, your loan will be prime plus 0.5%.
What affects the prime rate?
The prime rate isn’t determined by one single factor. That said, arguably the greatest influence is the level of the Bank of Canada interest rate. The Bank of Canada, the nation’s central bank, cuts the rate when it wants to make the economy grow faster, while a Bank of Canada interest rate hike is implemented to cool the economy down (such as when the inflation rate is too high). Commercial bank rates are influenced by the central bank’s target rate because the Bank of Canada aims to set the rate at which banks lend to other banks.
Why should investors care?
If you aren’t borrowing money, should you even care about the prime rate? A way of answering this is to say what you definitely should care about are the factors that cause the prime rate to fluctuate. So even if you don’t need to look at the prime rate itself, you’re affected by the variables that influence prime.
Which brings us to GIC rates. The prime rate has to do with lending, whereas GICs are deposits. But they’re connected because they’re both influenced by the level of short-term interest rates in the economy. So when interest rates fall, prime falls. But GIC rates also fall.
Why are rates so low?
Believe it or not, before the global financial crisis, it was possible to earn 4.2% on a five-year GIC. That’s according to data from London Life that we examined back in a 2015 article. Today, 2.25% is the best GIC rate in Canada.
What happened? In short, due to the financial crisis, central banks around the world took their policy rates to very low levels (slightly negative in some countries, actually). But now, almost a decade after the onset of the crisis, our central bank’s key interest rate sits at 0.5%. Prime has plummeted in the process and so have GIC rates. In essence, borrowing has become cheaper and saving has become less alluring due to these ultra-low interest rates.
Of course, this doesn’t mean you shouldn’t save. What’s very important, however, is you try to ensure that the money you’ve parked away is not meaningfully being eroded by the deadly effects of inflation.
In this regard, if you want to have some of your funds sit in deposit products, it’s best to avoid regular savings accounts that pay almost no interest (0.05% is not uncommon) and instead look for the best deal on either a GIC or a high-interest savings account.