Interest rates are a key component of the Canadian financial system. They influence the cost of borrowing for consumers and businesses, impact returns on savings, and are a major tool used by the Bank of Canada to manage economic growth and inflation. High interest rates and low interest rates can have broad effects on short term and long term financial goals, whether they be term deposits, tax-free savings account investments, or even emergency fund savings.
What determines interest rates in Canada?
Several key factors influence interest rates in Canada:
The Bank of Canada's Policy Rate: Known as the “target for the overnight rate,” this is the interest rate the Bank of Canada sets for overnight lending between commercial banks. It serves as a benchmark for other interest rates. Canada's central bank adjusts this rate to manage economic growth and inflation.
- Government Bond Yields: Interest rates on Government of Canada bonds impact rates for mortgages and other loans. Bond yields rise when bond prices fall, and vice versa.
- Inflation: Also known as the Consumer Price Index (CPI), higher inflation typically leads to higher interest rates as lenders demand greater returns to offset the decrease in the value of money over time. The Bank of Canada aims to keep inflation at 2%.
- Economic Growth: Stronger economic growth can prompt higher interest rates to prevent overheating. Weaker growth leads to rate cuts to stimulate borrowing and spending.
- Competition: Canada's major banks compete for customers. If one bank offers higher interest on savings accounts, others follow suit.
The role of the Bank of Canada
The Bank of Canada is the nation's central bank. One of its primary goals is to set monetary policy to preserve the Canadian dollar's value and keep inflation low and stable.
The Bank's Governing Council meets eight times yearly to decide on policy interest rates. It aims to balance economic growth and inflation through rate adjustments. If inflation rises above the 2% target, the Bank will likely raise rates to discourage borrowing and spending. If growth slows substantially, it may cut rates to stimulate the economy.
Changes to the target overnight rate influence the prime lending rates set by commercial banks for loans to consumers and businesses. Higher policy rates make loans more expensive, while rate cuts make borrowing cheaper.
Current interest rates in Canada
Here are the current interest rates across major Canadian financial products as of November 2023:
- Overnight Lending Rate: 5.00%. The Bank of Canada's policy rate is a benchmark for other interest rates.
- Prime Lending Rate: 7.20%. The rate commercial banks offer their lowest-risk customers. It moves in tandem with the overnight rate.
- 1-Year Government of Canada Bond Yield: 4.982%. Drives fixed mortgage and loan rates.
- High-Interest Savings Accounts: Up to 6.0%. Top promotional rates from online banks. This is not a regular savings account; many promotions are for online banking only. Though a HISA is often the best option for savings, some banks require a minimum deposit to access their best rates or annual percentage yield.
- 1-Year Guaranteed Investment Certificates (GICs): Up to 5.65%. Low-risk, fixed-return investment.
- 5-Year Fixed Mortgage Rates: 5.64% average for uninsured mortgages. A variable rate mortgage will typically be pegged to the prime rate.
- Credit Card Interest Rates: Up to 29.99% for purchases and cash advances. Consumers can likely find a lower rate but they have to be aware of potential monthly fees.
Factors driving current high rates
Interest rates have increased significantly since early 2022 due to surging inflation. The annual inflation rate peaked at 8.1% in June 2022, the highest level since 1983.
In response, the Bank of Canada raised its policy rate from 0.25% to 5.00% over 10 months to cool economic growth and bring inflation back to the 2% target. This has driven up the rates borrowers pay and the returns on savings.
Other factors pushing rates higher include:
- Strong economic recovery from the pandemic.
- Rising wages and high consumer demand outstripping supply.
- Rebounding oil and commodity prices following the downturn in 2020.
Impact of interest rate changes
Changes to interest rates can have a significant impact on consumers and the broader Canadian economy. When the Bank of Canada raises its benchmark interest rate, known as the policy rate, it filters through the financial system. It impacts the interest rates that banks and other lenders offer consumers.
It makes the cost of debt higher
Higher interest rates make it more expensive for consumers to borrow money. For example, interest rates on variable-rate mortgages, home equity lines of credit, car loans and credit cards will rise when the policy rate increases. This means higher debt servicing costs for Canadian households, leaving them with less disposable income for other goods and services.
It gives you higher returns on savings, GICs, and bonds
Conversely, higher interest rates allow savers to earn more interest income through vehicles like savings bank account, GICs and bonds. However, a chequing account generally will not offer a higher rate of return. While rising rates motivate consumers to save more, higher borrowing costs dampen consumer spending and economic growth.
Changes to the policy rate also impact business lending rates offered by banks. With lower interest rates, businesses can access credit more cheaply to invest in new equipment, technology, and expansion. These investments become more expensive with higher rates, potentially causing businesses to scale back spending plans.
Foreign exchange rates are also impacted
Interest rates impact the Canadian dollar exchange rate as well. Higher rates tend to boost demand for the Canadian dollar among foreign investors looking to earn a better return. This causes the dollar to appreciate. A higher dollar makes Canadian exports more expensive for international buyers, hurting export-oriented industries.
The federal government uses interest rate adjustments to meet its 2% rate of inflation target and promote a healthy economy. Lower rates stimulate growth by encouraging borrowing and spending, while a higher rate of interest keeps inflation in check by making borrowing any amount of money more expensive. Based on a high annual percentage rate, interest payments seriously strain household spending.
Getting the balance right is tricky. Unexpected rate hikes can tip heavily indebted households into financial distress. Meanwhile, rates that remain too low for too long can feed excessive borrowing and inflate dangerous asset bubbles.
Canadians with variable-rate debts must budget for rising interest costs when the Bank of Canada signals plans to raise rates. At the same time, savers should shop around for the highest deposit rates on offer when rates start to climb. Understanding the impact of interest rate moves is crucial for consumers to make informed financial decisions and gain some peace of mind. Understanding these impacts is especially important when considering special offers or putting money in investment vehicles such as a Registered Retirement Savings Plan (RRSP), Guaranteed Investment Certificate, mutual funds, the Canadian market, or the broader financial markets.
Comparing rates among financial institutions
With interest rates rising, consumers need to compare rates offered on savings accounts and GICs at the major Canadian banks versus smaller financial institutions. While the big banks often benefit from broad public awareness of their brands, smaller competitors increasingly offer better rates.
For example, Alterna Bank and EQ Bank regularly offer higher annual interest rates than the big banks. The smaller size of these institutions allows them to operate with lower costs. These smaller players attract new business by passing some of these efficiency savings to customers in the form of higher deposit rates.
The major banks have extensive branch networks and large sales forces pushing their products. But with online and mobile banking making geography less relevant, Canadians have been warming up to digital-only providers. Their national reach has allowed newer entrants to grow quickly in the banking landscape.
Credit unions are another source of competitive rates, especially on deposits. Operating on a cooperative model, credit unions return profits to members through better rates and lower fees. Credit unions are provincially regulated and carry CDIC deposit insurance up to $250,000, the same as the major banks.
While big banks tend to move in lockstep on rate changes, smaller players are sometimes willing to stand apart. For example, when the Bank of Canada slashed its policy rate to 0.25% in 2020, EQ Bank was the first to pass the full cut to customers by lowering its savings rate to 1.25%.
With hundreds of rate options out there, using comparison tools helps identify the best deals. Search for a third-party website to easily scan rates across banks, credit unions, trust companies and online providers. Taking the time to review the content of the third-party sites and compare rates can help Canadians earn more interest on the best savings accounts and pay less on loans such as a Home Equity Line of Credit.
Outlook for Future Rate Changes
Many economists expect the Bank of Canada to stop raising interest rates soon now that inflation shows signs of easing. Inflation slowed to 3.8% in September 2023.
However, the Bank's October 2023 Monetary Policy Report stated that “interest rates will need to rise further” and that rates could still increase or decrease to guide inflation back to 2% by 2025.
Most analysts predict the Bank will raise its policy rate by 0.25 percentage points to 5.25% in December 2023. This would be followed by rate holds through mid-2024 before potential cuts late in the year or early 2025.
The pace of future hikes and cuts will depend on incoming data on economic growth, job gains, and inflation. Upside risks like renewed supply chain issues or energy price spikes could lead to more aggressive tightening.
Overall, interest rates are expected to remain relatively high compared to the ultra-low levels seen over the past decade. Consumers and businesses should prepare for a rising rate environment into 2024.
In summary, interest rates are crucial to Canadian economic activity and the financial system. The Bank of Canada manages its policy rate to balance economic growth and inflation. Rates have risen substantially since early 2022 due to surging inflation, with the Bank's overnight rate increasing from 0.25% to 5.00%. This has flowed through to higher mortgage, loan, and savings account rates. Mortgage interest rates and variable interest rates will continue to strain consumers with high monthly payments.
While inflation shows signs of easing, the Bank of Canada interest rate is expected to remain relatively high compared to the past decade. The Bank of Canada will likely raise its policy rate in late 2023 before potentially cutting rates next year or in 2025. Consumers and businesses must prepare for a rising rate environment soon as the Bank seeks to continue to reverse inflation to its 2% target.
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