Definition:
The prime rate is the interest rate that banks and other financial institutions charge their most creditworthy customers for short-term loans. It serves as a benchmark for many types of loans, including mortgages, personal loans, and lines of credit. The prime rate is typically influenced by the central bank’s key interest rate, such as the Bank of Canada’s policy rate, and is adjusted in response to changes in the broader economic environment.

How the prime rate works

The prime rate is set by individual banks but usually follows the central bank’s policy rate. When the central bank changes its rate, banks adjust their prime rate accordingly. The prime rate is usually a few percentage points above the central bank’s rate, reflecting the cost of borrowing for the bank, plus a margin for risk and profit.

For example, if the Bank of Canada raises its policy rate, banks will often raise their prime rate as well, leading to higher borrowing costs for consumers.

The prime rate and its impact on loans

Many loans, especially variable-rate mortgages and lines of credit, are tied to the prime rate. When the prime rate increases or decreases, the interest rates on these loans typically follow suit. Here’s how the prime rate affects different types of loans:

• Variable-rate mortgages: The interest rate on variable-rate mortgages is often based on the prime rate, plus or minus a spread. If the prime rate rises, so does the interest rate on the mortgage, making monthly payments higher.
• Lines of credit: Personal lines of credit and home equity lines of credit (HELOCs) also typically follow the prime rate. A rise in the prime rate will increase the interest rate on these credit products, leading to higher repayments.
• Business loans: Many small businesses use loans with interest rates tied to the prime rate, meaning they can also face higher borrowing costs when the prime rate increases.

How the prime rate is set

The prime rate is primarily influenced by the central bank’s policy rate. In Canada, this is the Bank of Canada’s overnight rate, which guides the lending rate between financial institutions. When the Bank of Canada changes its overnight rate, the prime rate usually follows suit. Other factors, such as the overall economic environment and inflation, also play a role in determining the prime rate.

• When the economy is strong, the central bank may raise the policy rate to cool inflation, leading to an increase in the prime rate.
• When the economy is weak, the central bank may lower the policy rate to stimulate economic activity, causing the prime rate to decrease.

Why the prime rate matters

The prime rate is important for both consumers and businesses because it directly impacts borrowing costs. When the prime rate is high, loans and credit become more expensive, which can slow down borrowing and spending. Conversely, when the prime rate is low, borrowing becomes more affordable, which can stimulate economic activity.

For consumers, the prime rate affects:

• Mortgage costs: If you have a variable-rate mortgage, your interest payments will change with the prime rate.
• Loan interest: Many types of loans, such as personal loans and car loans, may have interest rates that are tied to the prime rate, making them more expensive if the prime rate rises.
• Credit card rates: Some credit cards have interest rates linked to the prime rate, meaning higher prime rates can increase credit card interest charges.

For businesses, the prime rate affects:

• Cost of financing: Businesses with loans tied to the prime rate will see higher costs if the rate increases.
• Investment decisions: High borrowing costs can lead businesses to delay or cancel investment plans.

How to track the prime rate

The prime rate is usually published by major financial institutions in Canada. You can check the current rate on the websites of banks, news outlets, or financial services websites. The Bank of Canada’s website also provides information on the current policy rate, which directly impacts the prime rate.

The prime rate and monetary policy

The prime rate is closely tied to the central bank’s monetary policy. Central banks use the policy rate to control inflation and influence economic activity:

• To curb inflation: Central banks may raise the policy rate, which leads to an increase in the prime rate, making borrowing more expensive and slowing down consumer spending.
• To stimulate growth: Central banks may lower the policy rate, which decreases the prime rate, making borrowing cheaper and encouraging businesses and consumers to borrow and spend more.

Understanding the prime rate

The prime rate is a key indicator in financial markets that reflects borrowing costs and helps to guide both consumer and business lending. By understanding how it works and how it is influenced by economic conditions, you can make better financial decisions and prepare for changes in borrowing costs.

Last modified: November 11, 2024