What are interest rates and why do they matter?

Interest-rate increases may be in the cards at home and abroad, thanks to high inflation numbers. But what is an interest rate, and how might increasing rates affect your portfolio?

Interest rates are one of the most important elements of any national economy. In Canada—as in many countries around the world—rates have been on a steady decline for the last four decades. Lately, however, fears that they have hit a bottom and rising rates will be the new norm have tensions high. 

What is an interest rate?

It’s critical to understand that “interest rates” is a catch-all term. There are many types of rates in an economy and depending on your financial situation, you may or may not be affected by each different one. It’s therefore important to understand the differences between the main types.  

Target for the overnight rate (aka policy interest rate)

What is it?

The main tool of the Bank of Canada (BoC). It’s used to stimulate the economy or cool it when inflation gets too high, and is the main driver of all other interest rates in the country.

Who determines it?

The BoC, on a schedule of eight fixed dates per year (though it can change on other dates under special circumstances).

Who’s most affected by it?

Directly, it’s Canadian banks that are affected by it. Indirectly, all Canadians since it’s the main driver of all other interest rates in the economy.

Bank rate

What is it?

Another tool for the Bank of Canada. It’s the rate at which Canadian banks can borrow money from the Bank of Canada for a single day.

Who determines it?

Again, it’s the BoC, on a schedule of eight fixed dates per year (though it can change on other dates under special circumstances).

Who’s most affected by it?

Directly, it’s Canadian banks that are affected by it. Indirectly, all Canadians since it’s the main driver of all other interest rates in the economy.

Prime lending rate (aka prime rate)

What is it?

The rate that Canadian banks use for their most credit-worthy customers. It acts as a baseline to set rates on other loans such as mortgages and lines of credit.

Who determines it?

Each bank sets its own prime rate, but there’s usually no difference between them. Banks will normally change their prime rate in response to changes in the bank rate (see above).

Who’s most affected by it?

Anyone who has or is considering a loan from a bank.

Savings accounts (and cash-equivalent) rates

What is it?

The interest rate banks pay customers to keep cash in their savings accounts or cash-equivalent securities such as guaranteed investment certificates (GICs).

Who determines it?

Each bank sets savings account rates for its different account types.

Who’s most affected by it?

Anyone who keeps cash in their accounts, or cash-equivalent securities.

Mortgage rate

What is it?

The rate paid for a mortgage loan. It can be fixed or a floating rate, based on the prime rate plus a spread (e.g., prime + 50 basis points).

Who determines it?

Each bank determines its own mortgage rate for each client, depending on the creditworthiness of the borrower (among other things).

Who’s most affected by it?

Directly, anyone with a mortgage or who is considering getting a mortgage. Indirectly, anyone invested in the real estate market (since mortgage rates affect house prices).

Bond rates

What is it?

The rate you can earn by buying a bond. Rates will differ depending on the type of bond, the issuer (usually, a government or business), and the maturity (how long until you get your capital back).

Who determines it?

Participants in the bond market (i.e., forces of supply and demand) determine the prices and rates for each bond.

Who’s most affected by it?

Anyone who owns, or wants to buy or sell bonds, either directly or through vehicles such as mutual funds or exchange-traded funds. The issuers of the bonds are also affected, since they would have to pay more interest.

Why does the Bank of Canada change interest rates?

The mandate of the BoC is to keep inflation in check—specifically, to keep it within a range of 1% to 3%. The main tool it can use to control inflation is its target for the overnight rate (also called the policy rate). If the BoC sees inflation getting too high, it raises its policy rate, and this increase flows through to other rates (for example, the prime lending rate) in the economy. Rising rates cool the economy by discouraging people from borrowing money for purchases. This decreases the amount of consumer spending—higher interest rates mean people would be less willing to borrow money to spend on purchases such as houses and cars—and businesses spending, since business purchases are often bankrolled by loans, and also because their customers are buying fewer of their products.  

On the other hand, if the BoC sees inflation getting too low, it does the opposite, stimulating the economy by lowering rates to encourage borrowing and spending. 

How can rising interest rates affect me?

Depending on your personal situation, you may be affected by some interest rates, but not others. In general, there are two ways that interest rates may affect you: through your investments and through your personal finances.

Investments

  • Bond prices are inversely affected by interest rates. As rates go up, bond prices go down (not perfectly in tandem, but as a general rule).
  • Any real estate holdings (either through your portfolio or simply by owning your house) may be affected. Rising rates discourage home buying and make it more expensive to pay a mortgage, so the real estate market often suffers.
  • Cash and equivalents tend to do a little better, since rising rates flow through to savings accounts and GICs.

Personal finances

  • If you have a variable-rate mortgage, rising rates mean it will be more expensive to pay that mortgage (though depending on your mortgage, your payments themselves might not change; the increasing rates might mean a longer amortization period). If you’re on a fixed-rate mortgage, you might be affected when it comes time to renew.
  • Lines of credit generally have variable rates, so rising rates may increase your payments. Other large purchase on credit such as a car loan will likely get more expensive.
  • If you’re a small business owner and you have a loan or are considering one, it’s likely that it will cost more in a rising rate environment. 

"Interest rates will need to increase to control inflation. Canadians should expect a rising path for interest rates."

Bank of Canada Governor Tiff Macklem, January 26, 2022.

Are interest rates going up?

Notwithstanding some short-term blips, generally, interest rates have been on a steady decline for four decades in Canada. Rates on Canadian government bonds, for example, hit an all-time low in 2020, as did mortgage rates.

Rates have been on a decline for four decades, but what's next?

Government bond, mortgage and policy rates in Canada

Line chart of mortgage rates, 10-year bond rates and the BoC policy rate since the 1980s. They have all been on a consistent downward trend.
Source: Manulife Investment Management, Macrobond, Bank of Canada, as of January 26, 2022. Bank of Canada policy rate is the target for the overnight rate. Mortgage rates are 5-year convential mortgages via Bank of Canada data. 

But with inflation heating up, market-determined interest rates such as government bonds have begun to creep back up, in the expectation that the BoC—not to mention its American equivalent, the U.S. Federal Reserve (Fed)—will begin to hike rates. No one can tell for certain, but despite keeping rates on hold at it's January 2022 meeting, the BoC nevertheless said that it expects to raise its policy rates in the near term, as did the Fed.

Wherever rates go, it’s critical to understand the impact that various types of interest rates might have on your finances, both as an investor and as a consumer. 

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