The announcement yesterday from the Bank of Canada that it lowered the target overnight rate to 3/4 per cent has been called the most significant rate announcement in the last 10 years. So the obvious next questions are…
How does this rate change affect me? How does this rate change impact my ability to buy a new home? Do I have increased purchasing power now?
Well… let’s work this through.
Bank of Canada
The Bank of Canada sets what is called the “overnight rate” which has more to do with how banks borrow money among themselves than it does have a direct impact on consumers. However, according to the Bank of Canada website,
“Changes in the target for the overnight rate influence other interest rates, such as those for consumer loans and mortgages.”
So basically the overnight rate can influence the prime lending rate, but it doesn’t have to… the banks decide that for themselves and subsequently for us.
The prime rate (currently 3%) is what Variable Rate Mortgages are based on. A typical variable rate mortgage will have a component plus or minus to prime. So if the prime rate is 3% and the component is -.5%, your contract rate would be 2.5%. When the lender changes the prime rate, your rate goes up or down accordingly.
The confusion is a result of a lot of people believing the overnight rate is the prime rate. The over night rate is currently 0.75% whereas the prime rate is still 3%. As of right now, there has been no changes to mortgage rates as a result of the Bank of Canada announcement.
Will Rates Go Down?
Typically the prime lending rate does go down when the Bank of Canada lowers the overnight rate. However this is up to the banks to decide. The banks could decide not to pass along this decrease in their expenses to consumers and just hang on to the profitability. TD bank is already on record as saying they will not be lowering their prime rate in response to this latest Bank of Canada move.
“TD Bank said Thursday it had decided not to cut its prime rate, a decision that “was carefully considered and is based on a number of factors, with the Bank of Canada’s overnight rate only being one of them.” Royal Bank of Canada said it is “considering the impact” of the central bank’s rate cut, but is not changing its mortgage products at this time. Scotiabank told CBC News it had not yet made a decision on whether to cut its prime rate.”
“Our decision regarding our prime rate is impacted by factors beyond just the Bank of Canada’s overnight rate,” said Mohammed Nakhooda, a spokesman for TD Bank. ” Not only do we operate in a competitive environment, but our prime rate is influenced by the broader economic environment, and its impact on credit.”
It is still to be seen what all lenders will do, they are no doubt taking their time to consider all options (while they make more money in the short term).
Even if all the lenders across the board do decide to lower their prime rate to 2.75%, this will have an impact on current variable rate holders and it will not increase the purchasing power of anyone purchasing a property and securing the mortgage with a variable rate. This is because:
To qualify for a variable rate mortgage, you qualify at the benchmark rate, instead of the contract rate.
The benchmark rate is currently 4.79%, so in order to qualify for the variable rate (which is currently in the mid to low 2% range), you have to be able to afford to qualify at the higher rate. These rules are in place so that when the variable rate mortgage renews in 5 years… there is no significant shock in payment increase if the lending landscape is drastically different.
Now, with the recent drop in oil prices, the Canadian dollar falling and the bond market taking a dive as a result of the Bank of Canada rate change, many are predicting that fixed rates will be going down as well.
Unlike the variable rate a 5 year fixed rate is qualified on the contract rate not the benchmark rate. So if the 5 year fixed rate does goes down it will actually increase the purchasing power of a homebuyer.
So, to answer the question directly, will this rate decrease impact the purchasing power of the average homebuyer. No it will not.
There will be less interest paid by variable rate holders but someone purchasing a property with a variable rate will not have any more purchasing power. While someone purchasing a property with a 5 year fixed rate will qualify for more, their rate is in no way tied to prime and they won’t see any savings from the lower rate (if it does go down).
It is good to note that the cost of borrowing money to purchase a home in Canada has never been this cheap. Any extra money paid towards principal will have a huge impact. It would seem that rather than try to use these low rates to purchase a more expensive house, the best plan of action would be to use these low rates to pay off your mortgage more quickly.
But as everyone’s situation is different, it’s hard to give general advice. I would love to talk with you about your situation and help you figure out the best mortgage product for you!