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."
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 are now starting to rise
Government bond, mortgage and policy rates in Canada
Source: Manulife Investment Management, Macrobond, Bank of Canada, as of September 7, 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 having reached levels not seen in decades, in March of 2022, the Bank of Canada announced its first rate hike since 2017 (as did it’s American equivalent, the U.S. Federal Reserve). Market-determine rates such as the prime rate, mortgage rates and the Canadian government 10-year bond rate all followed suit, having increased over the year.
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.
Important disclosures
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients and prospects should seek professional advice for their particular situation. Neither Manulife Investment Management nor any of our affiliates or representatives (collectively Manulife Investment Management) is providing tax, investment or legal advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Manulife Investment Management shall not assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment approach, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social ,and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Manulife Investment Management
Manulife Investment Management is the global brand for the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship and the full resources of our parent company to serve individuals, institutions, and retirement plan members worldwide. Headquartered in Toronto, our leading capabilities in public and private markets are strengthened by an investment footprint that spans 18 geographies. We complement these capabilities by providing access to a network of unaffiliated asset managers from around the world. We’re committed to investing responsibly across our businesses. We develop innovative global frameworks for sustainable investing, collaboratively engage with companies in our securities portfolios, and maintain a high standard of stewardship where we own and operate assets, and we believe in supporting financial well-being through our workplace retirement plans. Today, plan sponsors around the world rely on our retirement plan administration and investment expertise to help their employees plan for, save for, and live a better retirement.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
2413633
