How do interest rates work in Canada?

As the old saying goes, “It takes money to make money.” (There is also an old saying that goes, “That’s showbiz, baby!” but that’s not what this article is about.)

When you put money away, you want that money to grow by earning interest. And when you borrow money from the bank, be it short term like on your credit card or long term like on your mortgage, you know that the financial institution that lent it to you is earning money off of you, usually in the form of interest.

The Bank of Canada interest rate as of July 12, 2023 is 5.0%

So how does the money make money? Maybe you’ve read about how to pay off your credit debt, and how to pick the perfect savings account. Both are matters of looking at interest rates and your financial goals. But, interest...how does it work? And how do interest rates affect your financial health?

Here’s a no-nonsense overview on how interest rates are set, and what the fluctuations mean.

Let’s start with the Bank of Canada.

The Bank of Canada is a crown corporation, which means it’s owned by Canadians (hey, that’s us!). While the Bank is technically the property of the Federal Government, it operates with a large degree of independence from our elected officials. (This independence puts a check on government power to safeguard our economy and financial system from political exploitation.)

The Bank of Canada exists to regulate and monitor the Canadian financial system, and to help keep the rate of inflation stable and low so that our national economy can grow rather than shrink. It acts as a research institution, surveilling how many economic growth factors affect the value of Canadian money, and sets the policy interest rate.

What is the policy interest rate?

So this is just a tiny bit complicated. The Bank of Canada interest rate (policy rate) is also called the ‘Overnight Rate,’ because it is the interest that the major Canadian banks charge each other for overnight loans.

Let’s back up a bit. For the big Canadian banks to be able to cover the daily transactions of their customers (including individuals, businesses, and investment funds), they need to have access to large and fluctuating amounts of money. In order to have that access, the large banks lend each other large amounts of money electronically overnight, and repay the money at the end of the next day’s transactions. This lending and repaying is called the overnight market.

The overnight rate, or policy interest rate, is the rate of interest on these loans between the major banking institutions.

"The Bank of Canada exists to regulate and monitor the Canadian financial system, and to help keep the rate of inflation stable and low so that our national economy can grow rather than shrink."

Okay, but I’m not a bank? What does the policy interest rate have to do with me?

When the Bank of Canada lowers or raises the overnight rate, it factors into the way commercial banks apply interest on credit they’ve extended (like, say, a credit card, mortgage or line of credit), and what they agree to pay as interest on their savings products (for instance, a high interest savings account).

So a lowering of the policy interest rate typically means the banks will change their interest terms—for both credit they’re lending out and interest they pay on savings and investments.

In general, when the Bank of Canada changes the policy interest rate, it sets off a chain reaction that affects lending rates from every bank. Each bank determines their own “prime lending rate,” which is itself primarily influenced by the Bank of Canada’s policy interest rate.

Each commercial bank uses their prime rate as the building block for many different lending services. But you probably, like most consumers, think of the prime rate as being significant to mortgages specifically.

Okay, but why is a higher interest rate good and a lower one bad?

Truthfully, it depends on where you’re at in life.

When the interest rate takes a dip, as it did after the arrival of COVID-19 in 2020 or the sub-prime mortgage crash in 2008, it generally makes debt less expensive and savings less lucrative.

So if you have a variable rate mortgage, the lower rate means you’ll be paying less in interest. The same goes if you’ve taken out a Home Equity Line of Credit.

A lower policy interest rate usually means the banks are setting a lower prime rate on mortgages, so if you’re looking to buy property it’s advantageous to do so while the rate is low, in part because you’ll be better positioned for a mortgage stress test.

However, a lower rate can mean your savings take a ding. Especially if you’re retired or living off a fixed income from a savings fund, you might feel a little crunch. If your fund is set up to be invested with guaranteed interest, as with a GIC or HISA, the rate of return on your investment will take a dip.

That said, if you own property, the lowered mortgage rate will likely protect the growing value of that property, because the lowered mortgage rate helps stimulate market demand.

Monetary Policy Strategies

Monetary policy strategies function like the blueprint for the Bank of Canada's operation. Gradual adjustments in the Overnight Rate, influenced by the Canadian economic climate, evolve from these strategies, steering both the lending practices and investment returns in the financial market. These strategies are far-sighted, centering around maintaining economic stability, curbing inflation, and promoting economic growth. A major component of this is the juggling act between lending practices and savers' benefits, setting the stage for a balanced economic growth spurt.

Quantitative Tightening and Easing

Agile monetary policy strategies necessitate economic mechanisms like quantitative tightening and easing. These measures adjust the amount of money in circulation, thereby shaping the overall economic landscape. During periods of quantitative easing, the Bank of Canada ups the ante by buying up government bonds and other securities. This drives an infusion of money into the market, thereby making borrowing cheaper and encouraging spending.

Contrarily, when indicators signal an overheated economy, in which inflation runs rampant, quantitative tightening takes the reins. Selling off government securities diminishes the amount of money swirling in the market, nudging the economy back onto a sustainable track. It's a fine balancing act that helps maintain financial wellness.

Targeted Inflation Rate and Its Significance

The "vibe check with spreadsheets" mentioned earlier in the article can also refer to the targeted inflation rate. Simply put, the targeted inflation rate is like the pulse rate of our economy, a snapshot of economic health. Keeping this rate in a flexible range of 1% to 3% implies that our economy is neither underperforming nor overheating. A stable inflation rate is often indicative of a robust economy where growth sustains, prices are predictable, and consumers and investors make sound financial decisions.

Role of Interest Rates in Economic Stability

As you may have discerned by now, the interest rate is the fulcrum upon which the seesaw of economic stability rests. Low interest rates stimulate borrowing, fuel business growth, and spur consumer spending, thus giving a shot in the arm to economic expansion. Conversely, raising interest rates cools down an overheated economy by reducing borrowing and spending tendencies.

Interest rates influence everything from your daily grocery shopping to your retirement fund's growth. By establishing a solid understanding of how interest rates operate, you can navigate the ebb and flow of economic changes, ensuring your financial well-being parallels the overarching drive for economic stability.

What other factors affect the way commercial banks do interest?

Commercial banks set interest rates for both credit and savings products in a way that sets the bank up to turn a profit. This is why, duh, the rate of interest a bank pays you on a savings account is likely to be lower than the interest rate that same bank collects from you on a line of credit. (This also might explain why many commercial banks are often trying to maintain minimum account balances, get you to pay various kinds of account fees, and sell you more credit…)

The Bank of Canada’s policy rate is one of the major external forces that commercial banks use to determine how interest is set.

Other major external factors include things like:

• What the bank has in assets—if it has extended more credit than it can reasonably cover, for example.

• The price value of those assets—for example, does the mortgage on a property match the current price valuation of that property?

• The global currency exchange rates, or the strength of the Canadian dollar.

• The expectations commercial banks and consumers have about the economic growth outlook. Like a vibe check, but with spreadsheets.

Typically, the Bank of Canada adjusts the policy interest rate on eight predetermined dates throughout the year. When the Bank of Canada decides to make an unannounced change, like in March 2020, it can feel scary and confusing. It’s normal to feel anxiety when things change suddenly. In general, the Bank of Canada is acting to create a sense of long term economic stability for Canadians.

That’s the long term. In the short term, arming yourself with knowledge about how interest works, how to manage debt, and how to make the right decision about what to do with your savings will empower you to take control of your financial health.