How Does the Prime Rate Affect My Mortgage Payments?
When preparing to get a mortgage, many people wonder how changes to the prime rate will affect their mortgage payment.
The prime lending rate or prime interest rate is the annual interest set by major financial institutions. Lenders offer the prime interest rate to their most creditworthy commercial customers. Financial institutions also use the prime interest rate as a baseline rate for all types of loans and lines of credit. So if you decide to get a variable-rate mortgage, changes to the prime rate can have an impact on your payments.
To better understand the impact changes to the prime rate has on mortgage payments, it helps to understand what the prime rate is. Financial institutions set their prime interest rates based on the Bank of Canada’s overnight rate, or Bank of Canada interest rate. The connection between the overnight rate and the prime interest rate often leads to confusion.
The overnight rate set by the Bank of Canada isn’t the same as the prime interest rate. The overnight rate is the interest rate large financial institutions use to borrow and lend one-day funds (or overnight) from each other. Prime rates are set by individual lenders and vary from institution to institution, although they usually don’t differ by a large margin. The overnight rate sits at 0.5% and most major banks currently have a prime rate of 2.7%.
The variable mortgage rate you agree to will be based on the prime rate plus or minus a fixed percentage. So if you have a variable rate mortgage, the rate will go up or down by the same amount as the prime rate. The underlying risk of most variable-rate mortgages is these fluctuations could mean that the cost of your mortgage will increase when rates increase. Generally, the payments will stay the same but more of your payment will go towards paying interest and less will go towards principal.
However, the Bank of Canada has maintained a 0.5% overnight rate since 2015. In addition to the past trend, current forecasts and comments from the Bank of Canada seem to indicate that the overnight rate will remain at 0.5% for some time or there could potentially be a cut depending on external factors. The likelihood of a Bank of Canada interest rate hike any time soon remains very remote. This means the prime rate is likely to stay where it is or it may decrease.
If you’re very risk averse, you might want to consider a fixed-rate mortgage, which has a higher interest rate but the amount that will go towards paying interest won’t increase during the term. Your first step should include research to find the best mortgage rates, which will help you to assess whether a variable rate is right for you. Once you’ve considered your options, a mortgage broker can help you get the best rate.