January 17, 2018 update: The BoC again raised its benchmark rate by 0.25% to 1.25%. This is the third time it has raised rates since the summer of 2017, and rates are now the highest they have been since the financial crises of 2009. As expected, banks are already hiking their prime lending rates as well.

It’s been nearly 7 years since the Bank of Canada (BoC) last raised its key interest rate. Following the financial crises and it’s after-effects re: sluggish world economy, interest rates have  generally been on the decline. However, on July 12, 2017, the BoC hiked its overnight rate from 0.5% to 0.75%.

On September 6, 2017, following stronger than expected economic growth, the BoC again raised its benchmark interest rate by 25 basis point to 1%. This marked the second rate hike in less than 2 months!

What’s Important About the BoC’s Rate Hike?

To put things into perspective, the “overnight rate” set by the apex bank is the rate at which commercial banks are able to lend and borrow from one another in the short-term (i.e. overnight). The overnight rate goes on to influence the “Prime Rate” which is the rate set by the major banks in determining the interest you pay on variable loans and lines of credit.

Essentially, all variable loans like variable mortgages, HELOC, variable personal loans, and lines of credit are affected.

To summarize:

↑ in overnight rate by BoC = ↑ Prime Rate = ↑ interest rate on variable loans = ↑ funds required to settle debt over time.

What’s the reason for all the Rate Hike Hoopla?

Raising and lowering the central bank’s key interest rate (i.e. overnight rate) is one of the mainstays of what is known as Monetary Policy.

Monetary policy can either be expansionary or contractionary, depending on the inflation rate. The Bank of Canada sets a target inflation rate (rate at which prices of goods are rising) and then uses tools at their disposal (for example, interest rates) to manage the money supply.

To simplify BoC’s intentions, if inflation is high (things are getting overly expensive), interest rate is increased to make borrowing less attractive, decrease the money supply, and curtail inflation. This strategy also works in the reverse.

Other factors considered when deciding on monetary policy include: level of unemployment and currency exchange rates.

How Does an Interest Rate Hike Affect You?

1. Mortgages: The recent increase in the key interest rate is already being reflected in variable rate mortgages. The 5 biggest banks (RBC, CIBC, TD Canada Trust, Bank of Montreal and Scotiabank) have already hiked their prime rate again by 0.25 points – from 3.20% to 3.45%. This way, they are effectively passing the full cost of increases in interest rates to borrowers. The increase in variable mortgage rates will eventually trickle down to fixed rate mortgages as well.

2. Personal loans and lines of credit: All personal loans and lines of credit with a variable interest rate will see an increase in interest payments and overall cost of debt.

3. Home Equity Line of Credit (HELOC): If you have taken out an HELOC for home renovations, you will also feel the pinch. Interest rates on HELOCs are usually variable and tied to the bank’s prime rate (e.g. Prime + 0.50%).

4. Bank Savings: Savings accounts generally do better under a regime of higher interest rates. While the current rate hike is minimal and may not have as pronounced an effect, the general rule is that your savings account benefits as interest rates climb.

5. Stronger Currency: Higher interest rates attract more investment (both foreign and local). The increased inflow of funds for investment raises the demand for the local currency and may also raise its value. If the value of the Canadian dollar increases, your personal wealth is impacted positively i.e. the money in your pocket has more value because your purchasing power has increased. As of today, September 6, 2017, the loonie reached a high of 82.30 U.S. cents – its highest level against the U.S. dollar since June 2015.

Final Thoughts

If you have other variable rate debt that are not a mortgage, it may be prudent to pay them down as soon as you can. Pay off or pay down all high-interest debt first before accelerating or paying more on your mortgage – which often has an interest rate that is lower.

With all the talk of further interest rate hikes (monetary tightening) in the U.S., it’s more likely that we are in an era of progressive rate hikes here in Canada as well. When your other debts are paid up, you can increase or accelerate your mortgage payments in order to significantly lower your overall mortgage interest payments.

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