How Interest Rates Are Really Determined

How Interest Rates Are Really Determined

For the first time in seven years the bank of Canada increased their overnight lending rate. This change will impact the personal finances of millions of Canadians by increasing their interest rates by .25%. While the impact may look small, it can easily lead to thousands of dollars in increased interest expenses and marginally increased debt payments that will reduce their cash flow. 

This week we’re going to pull the veil aside and expose the “magic” that the Bank of Canada uses to change the interest rates that you receive. We’ll also explore the difference between the overnight lending rate, prime rate, and your rate.

I hope that you enjoy the article. You can find more about Toronto’s own non-biased financial literacy coach here.

The Overnight Lending Rate

It all begins with the Bank of Canada (BOC). The BOC attempts to manage the economy through a series of policies that can stimulate or slow the economy; this is formally known as monetary policy. The BOCs main target is to keep inflation at 2%.

The main tool at the BOC disposal is called the overnight lending rate.

The overnight lending rate target is raised and lowered to maintain, stimulate or slow economic activity. For example, if interest rates are increased then lending is more expensive, less lending will occur, and economic activity will marginally slow. The reverse is also true.

Recently, the BOC decided to increase their overnight lending rate from .5% to .75%. Their first increase in 7 years.

The overnight lending rate is very different than the rate that you pay, known as prime rate. The overnight lending rate is the target interest rates that banks will pay/receive when they lend to each other to balance their settlement accounts at the end of each night.

For example, bank A gave out more money than they took in and therefore have a negative settlement balance. Bank B has an excess settlement balance and decides to lend money to bank A. Optimally, they would charge the overnight lending rate of .75%

All nightly settlements for financial institutions must go through the Bank of Canada. So to nudge the banks along, the BOC also will lend and borrow money to the banks to balance their settlement balances. However, the BOC does this at a rate that is not as attractive than what other banks can offer each other.

The BOC lends money at a rate that is .25% above the overnight lending rate and pays interest on deposits that are .25% below the overnight lending rate. This makes it in the banks best interest to borrow and lend to each other at more attractive rates.

Continuing the example above, if the banks didn’t lend to each other then bank A would have to borrow from the BOC at a rate of 1% and bank B would deposit the funds at the BOC with a return of only .5%. Therefore, it’s in the bank’s best interest (pun intended) to lend to each other at .75%.

After all this is done, this guides the short-term interest rates that then affects all other interest rates.

While not discussed here, the BOC also uses other tools to help support their targeted overnight lending rate. These included special purchase and resale agreements, sale and repurchase agreements, and settlement balance requirements. The general idea is to add or remove liquidity from their operations.

Prime Rate to Your Rate

The short-term rate then translates to the major bank’s Prime rate. Typically, the banks charge 2%ish above the overnight lending rate – eg. Current prime is 2.95%. Prime is the base rate that a bank will offer their clients with optimal lending conditions, although some banking products like variable mortgages can be below prime.

For the typical borrower, the bank will then charge an additional spread on top of prime. This spread is determined by your personal circumstances like collateral used, credit history, capacity for debt, risk, and much more. Banks will also add a profit mark-up on prime rate as well.

When all of these variables are used, the financial institution calculates your rate. And that’s how your interest rate is determined!

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