Falling Interest Rates and You!

Falling Interest Rates and You!

On Jan 21st 2015, the Bank of Canada surprised investors by cutting their overnight lending rate from 1% to .75%. Simply, the overnight lending rate is the interest rate that Canadian banks borrow at to cover their daily operations. This rate ultimately shapes the commercial banks’ prime rate (what we pay).

Typically, the banks always change their prime rate with this change but this time they stubbornly refused to drop their rate. It took a whole bunch of pushing and prodding to finally get the banks to adjust their rates and even then they only decreased their prime rate only by .15% (compared to .25%). Their verbal responses were just as defiant, such as RBC’s.

Addition: The Bank of Canada dropped the overnight interest rate by a further .25% in July, 2015

“Our decision was driven by a number of factors, including our wholesale funding costs, the competitive, operating and macroeconomic environments, and the Bank of Canada’s recent rate decision and its impact on other market rates across the yield curve.”

Now that rates have changed, what does this mean to you? Since the change was minimal, probably not a whole lot. We’ll begin with the nice part.


The Good

Whenever prime rate decreases, so do all variable lending rates (non-fixed rates). The rate cut will be passed on to existing borrowers and possibly new borrowers (although banks may raise their other spreads on top of prime). This includes variable-rate mortgages, loans, lines of credits, student debt and more. The proportion that you’ll save will actually be different for each credit product because interest rates compound differently ex. mortgage rates compound twice a year and loans compound twelve times a year. However, due to the large value of mortgages, the total dollar amount that you save will likely be the largest for this product.

For example, there would be a mortgage saving of about $3,500 during a full 5-year term (assuming: no further rate changes, $300,000 mortgage and 25 year amortization). Of course, the assumption that rates won’t change over five years is highly unlikely, but it illustrates the point that savings can be made on small interest rate changes.

Many of your lending payments may not even decrease because payments have been predetermined. The good news is that the extra payments will be applied to your principle and your loan will be paid off slightly faster than usual.


The Bad

Sadly, many lending products won’t be affected by the interest rate change. Credit cards and fixed-rate lending products, like fixed mortgages, will notice no change. The only time that a fixed-rate product will be affected is if your renegotiate the contract.

Other than mortgages, the realities of such a small interest rate is very minimal. For example, a .15% interest rate drop on a $5,000 loan held for a full 5 years (assuming no further rate change) would only save you only about $20. The assumption is unrealistic and almost not even worth thinking about.


The Ugly

The real sad outcomes of a rate cut are the dismal rates offered on savings account, GICs and most government bonds. The reality is that you’re actually losing money when you hold these investments. Stated inflation is currently 1.5% (yearly rate), but most key goods are even greater. The reason for this discrepancy is due to drops in oil prices. For example, food prices are up 3.7%, shelter costs are up 2.4% and the list goes on. Plus, inflation is regional and Ontario is above average at 1.9% (includes oil).

Current savings rates offered by the banking industry range from 1.3% to nothing. You’ll be able to find mildly greater rates as promotions and smaller unknown banks, but these are temporary and possibly risky. These low rates are causing a migration of money into other assets in search of higher rates.

Overall, this rate change will benefit some people and hurt others, but it will be a small impact due to the minimal adjustment. More importantly, it allows us to understand that this low-rate environment is here for a little while longer. How much long? That’s a good question that no one knows.