Prime Rate Impact on Mortgages: Explained

What is a prime rate?

A prime rate, also called a bank prime rate, refers to the interest rate banks use to set other interest rates, including mortgage rates. It's the rate banks charge their most creditworthy customers, typically large corporations.

The prime rate is tied to the Bank of Canada's (BoC's) policy rate, which can change or stay the same at the eight pre-scheduled rate 'dates' during the year when the central bank decides whether to heat or cool economic conditions.

The prime rate 'floats' and directly affects other floating interest rate products, like variable-rate mortgages and HELOCs (home equity lines of credit). It also indirectly affects the fixed mortgage rate market.

A higher prime rate usually means that all interest rates are higher (not including discounts that lenders may offer).

How is the prime rate set?

Bank prime rates follow central bank policy rate movements.

Banks don't have to follow the policy rate automatically. Instead, banks choose to follow rate movements, usually adjusting their prime rate within a day or two of central bank decisions.

It's rare for banks not to follow central bank rate movements. Past incidences of prime rate adjustment delays or varied responses (e.g., a partial adjustment) have occurred, but there have been no cases of outright ignoring policy rate guidance.

If banks ever decide not to follow a BoC rate move, it will be because the banking sector is concerned about undue financial damage.

Prime rates are set higher than the BoC policy rate.

Most bank prime rates are set with a spread of +2.20% above the Bank of Canada's policy rate. For example, when that policy rate is 4.0%, bank prime rates are then set at 6.20%.

Some banks may set their prime rate at a higher spread than +2.20% (e.g. at 6.35% from a policy rate of 4.0%). However, their borrowing rates to their best clients would still likely align with industry offerings, perhaps advertising a higher 'discount' off prime.

If you think you're getting a better prime-rate discount with a certain lender — make sure they're using the same prime rate as other banks (and beware, they may also make up for it with higher pre-payment penalties).

Prime rates vs. mortgage rates.

The prime rate sets the 'financial' temperature — and affects where banks set their mortgage rates.

Banks can't set any mortgage rate they want — they have to manage their expenses and revenue in line with current market conditions. So, a higher bank prime rate means you'll pay a higher mortgage rate overall.

But thanks to competition for your mortgage business, you may not have to pay a mortgage rate as high as the bank's prime rate.

Mortgage lenders may offer some term rates lower than prime for stronger mortgage applications, especially those that qualify for default insurance (called a high-ratio mortgage) and carry less risk.

Sometimes, that mortgage rate discount is as low as 2.20% off prime or even almost 3.0% lower, depending on whether the lender is a big bank or mortgage-only lender and based on the product terms and borrower's financial details.

How does the prime rate influence variable-rate mortgages?

The prime rate floats and directly informs other 'floating' interest rate products, such as variable-rate mortgages and HELOCs (home equity lines of credit).

A change in the prime rate means the same move for your variable mortgage rate. If you have adjusting mortgage payments, your payments will go up or down depending on the prime rate change. If you have fixed payments, your mortgage amortization will tick up or down according to the interest-cost difference (affecting whether more or less is going toward your mortgage principle).

Fixed mortgage rates point the way to prime rate movements.

The prime rate doesn't lead fixed mortgage rates up and down like variable rates. Instead, fixed rates anticipate where the prime rate is going before it gets there.

Fixed rates are based on a different interest-rate mechanism — the bond market, specifically bond yields. Yields have similar terms (such as 2-year, 5-year, and so forth), and banks set their fixed mortgage rates at a spread of 1% to 2% to compete with bonds to attract capital.

So where's the prime rate anticipation?

Bond traders trade government bonds all day, every day. They have a view on where they think prime rates will go over the next 5 years, and you can see their combined opinion changing in every bond price movement.

Traders often disagree. Half believe the 5-year bond yield will trade higher, and the other half think it'll trade lower. The middle ground is where the market lands (supply and demand finding an equilibrium) and is a tell for where the prime rate may be going.

So, when bond yields trend up (and fixed rates soon after that), the market expects the prime rate to rise, and vice versa.

5-year fixed rates are currently lower than a 5-year variable rate — usually, it's the other way around. The markets expect the prime rate to trend down, so the 5-year fixed rate already has its eyes fixed (down) on the future, waiting.

Note: The bond market is massive, much bigger than the stock market. And like most things financial, it can get complicated. Get a simpler explanation of bond yields here.

How does the prime rate influence alternative or B-lending mortgage rates?

The prime rate is used as a baseline for determining the market for alternative and B-lending mortgage rates.

Sometimes referred to as 'sub-prime' mortgages, these mortgage rates are set higher than prime rates to cover heightened borrower risk of default resulting from credit challenges or complex details and income sources.

Despite being charged higher rates, some Canadian homeowners rely on alternative lenders when a traditional bank says 'no.' These lenders are considered an essential part of the mortgage industry landscape and often help borrowers 'turn down' their financial pressures and make their way to a better rate.

Mortgage rates offered by private lenders are likely to be set even higher than alternative lending rates. These lenders are considered a mortgage strategy of 'last resort' if a borrower is turned down by traditional and alternative lenders.

What factors influence the prime rate?

Economic conditions influence the temperature setting of prime rates.

An overheating economy can quickly lead to higher price inflation, which can inflict significant economic damage if left unchecked by the central bank.

A hotter (higher) prime rate environment works to curb spending and growth, bring prices back in line, and restore more affordable conditions for everyday items and significant financial commitments, such as borrowing money to own a home.

Here are some of the main factors that can coax a cooler prime rate:

• Price inflation that stays within a 2.0% target (the BoC's primary focus)
• A stable unemployment rate of around 6.0%
• Job wage growth that stays in the 2% to 4% range
• GDP (Growth Domestic Product) of around 2% to 3% is considered a good benchmark for a healthy economy
• A bond yield market that anticipates a balanced economy (trending in alignment with a 'neutral' central bank rate, where the economy doesn't heat up or cool down)

Find your cooler (mortgage) temperature, with us.

Our highly trained, salaried True North Mortgage brokers offer cool-handed guidance to find your best mortgage rate and product for your unique situation (in your preferred language).

Having your budget run 'hot' due to higher rates and home prices can be stressful. Our mortgage-only focus and huge volume allow us to personalize your savings through a seamless, simple process.

Prime your rate savings from anywhere you are in Canada. We make it easy to get pre-approved or apply for a renewal or refinance online, over the phone, by email — or drop by a store near you.