The Learning Centre:
It pays to understand the Bank of Canada overnight rate increase.
Have a mortgage, credit card, or investments? The Bank of Canada overnight rate affects you.
Managing your money can be tricky. Between salary disruptions, creating an emergency fund, and making mortgage payments, staying in the black every month can be a challenge – particularly if you’re just starting out and in a lower pay grid. That’s why it’s important for education members to understand the Bank of Canada (BoC), how it works, and how changing its overnight rate could affect you, your money, and your plans.
Since July 12th, the headlines have been all over the newspapers and online. Unfortunately, if you’re like most consumers, you have only a vaguest idea of what those headlines really mean – that it probably will mean paying more interest on your mortgage. But here’s another newsflash: ANYONE who has a credit card, a line of credit or mortgage, who’s shopping for a new home or investing is affected when the BoC makes a change, such as the recent increase in the overnight rate from .50% to .75%.
How – and why – does the BoC influence interest rates?
Ok, here’s “BoC 101”. The BoC is the country’s central bank, and its role is to promote the economic and financial welfare of Canada. One of its financial responsibilities is monetary policy. The goal of monetary policy is to “contribute to solid economic performance and rising living standards for Canadians by keeping inflation low, stable, and predictable”. The BoC implements monetary policy by raising or lowering the target for the overnight rate, which is the interest rate at which major financial institutions borrow and lend one-day (or overnight) funds among themselves. All this can be found on their website.
Changes in the target overnight interest rate lead to changes in other market interest rates and therefore to changes in the demand for credit, the demand for money, and the demand for bank notes.
Did you know? “Inflation targeting” and why the BoC uses it.
Until the 1930’s, the objective of most countries’ central banks was to protect the country’s exchange rate. As inflation rates dropped, the central bank would become more restrictive about cash flow. Unfortunately, the result was the Great Depression, so this approach was, understandably, changed. For a time, central banks monitored and controlled employment numbers. By the 1990s central banks across the world started to adopt inflation rates as the primary target. Most central banks today focus on the control of inflation, believing that:
- High inflation is costly for individuals and damaging to the economy.
- Inflation is the only macroeconomic variable over which central banks have a systematic and sustained influence.
The conventional wisdom is that raising interest rates usually cools the economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation.
The BoC considers a 2% inflation rate to be the ideal.
Inflation targets in developed economies are usually set at 1% to 3% per year. Targeting an inflation rate that is too low or too high could create problems. An inflation target that is too low might lead to higher unemployment, restrict the central bank’s ability to support a recovery in times of recession, and increase the chances or frequency of deflation rather than inflation. Of course, no one wants to have an inflation target that is too high either, as inflation costs can be considerable.
Beginning in 1992, the BoC’s target range for inflation was 3–5 per-cent. This fell to 2–4 percent by 1993 and to 1–3 percent by the end of 1995. When the 2% goal was reached, it was judged to successfully deliver good overall economic performance. The BoC has examined the 2% target carefully over the years and considers the case for both a lower and a higher inflation target.
Have a mortgage? You’re going to pay more.
If you have a mortgage, how much – and when –you’ll feel the impact of the rate increase will depend on whether your mortgage is variable or fixed rate.
If you have a variable rate mortgage, the amount of interest you’re charged is tied to the overnight rate. Financial institutions pass on any increase in the rate to consumers almost immediately.
If you have a fixed rate mortgage, nothing will change until the fixed term ends and it’s time to renew. That’s because your rate is tied to the yield, or interest rate, of bonds. (It works like this: If the five-year Government of Canada bond is at 0.5%, the banks would take this rate and add percentage points to cover their costs and make some profit. If they add another 3.5% to that bond rate, their prime lending rate would be 4%. …which might be discounted in competitive markets for ideal borrowers.)
Will you pay more interest on debt?
Quick – is the interest on your credit card at a fixed rate, or is it variable? What about your line of credit? Your car loan? Do you know?
Some types of credit, such as credit cards, charge interest at a fixed rate, so their rate of interest would not increase with the BoC’s overnight rate. “Clients who are being charged a fixed rate on their credit card should still take action, though”, says Darryl Martella, Educators Financial Group Financial Advisor. “The rate of interest on some credit cards is so high, it’s one of the first places to evaluate when looking to save money.”
Have a line of credit (LOC)? Like a variable rate mortgage, is linked to the prime rate, and your rate of interest will rise. This is true whether your LOC is secured or unsecured.
This discussion has a punchline, though, which is this: the actual additional interest you’ll pay as a result in the BoC overnight rate increase is NOT the point. The point is that you ALWAYS need to be aware of how much interest you are paying on your debt, how to minimize that amount, and how it impacts your budget and financial saving goals. Talk to your Educators financial advisor about how you can minimize the interest you pay on the debt your owe.
Historically, an overnight interest rate increase has not affected housing costs, much.
Will the increase in the BoC overnight rate and subsequent increase in variable mortgage interest rates affect property prices? Let’s look at the history. In June 2010, the interest rate rose by .25%, followed by another hike to 0.75 per cent a month later and to 1 per cent in September, where it stayed for a few years. Data from the Toronto Real Estate Board and the Real Estate Board of Greater Vancouver show that property prices stalled for several months after the increases, after which the general upward trend continued in both cities.
Today, though, interest rate increases are not the only factor affecting the GTA housing market. The provincial foreign buyer’s tax, combined with stricter requirements to secure a mortgage have already resulted in GTA property prices cooling (the average price in June was $793,915, compared to $920,791 in April). Will the increase in mortgage interest rates add to the cooling effect? It’s a ‘wait and see’.
The education members most likely to be affected will be those buying their first home. When you’re saving for a down payment, and perhaps paying off a student loan, every penny counts. Maximize your savings and know exactly what you can afford by talking to an Educators financial advisor.
The .25% interest rate increase is not enough to make a big difference to savers.
Unfortunately, an increase in the overnight rate does not necessarily mean a corresponding increase in interest earned in a regular savings account. A high interest savings account (HISA) and a Tax Free Savings Account ((TFSA) – both of which you can get at Educators Financial Group – are still probably better savings options.
And if you’re thinking that returns on Guaranteed Investment Certificates (GICs) will rise, consider this: although banks increase the interest rate on mortgages quickly, the unfortunate fact is that the interest paid on a GIC is unlikely to increase as quickly. Some financial gurus actually disparage GICs as lagging behind the inflation rate.
Interest rate increase means bonds and stock valuations may be lowered.
Low interest rates have helped support fixed income (bonds) and stock returns over the past few years.
This may change. Rising interest rates drive bond prices down, and falling rates drive them up. Darryl Martella, Educators Financial Group Financial Advisor, explains why: “On the day a bondholder decides to sell his or her bond, current market rates determine the price. The bondholder will sell for less when interest rates are higher than the bond’s rate, and for more when interest rates are lower. Usually, the more years the bond is from maturity (the date of repayment), the bigger the price change.”
When it comes to stocks, the monetary policy over the past 8+ years has made them attractive. When the option is very low rates on GICs and bonds, investors tend to put more money into the stock market. In fact, many investors earned higher levels of income by buying dividend-paying stocks than they could on bonds and they had the opportunity for capital appreciation. As a result, stock prices continued to climb from their lows in 2009, with the exception of a few corrections along the way, and stock valuations are presently at much higher than historical levels.
Changes in interest rates can significantly affect stock prices, which may decline as companies pay more for loans and materials, causing lower profits.
Despite changes like the BoC overnight rate, your portfolio should be structured so that it continues to be on track to meet your financial goals while reflecting your tolerance for risk. You and your Educators Financial Advisor should discuss your portfolio on a regular basis, or whenever there are changes to your personal circumstances.
Have questions? Get one of our accredited Agent – Regional Directors to contact you.