Banks use prime rate as a baseline to set the interest rates they charge on mortgages. This means that if the prime rate increases, the rate for a new mortgage increases, and the same applies when the prime rate decreases. If you have a variable rate mortgage, these changes will happen during your term.
Each financial institution has the authority to set its own prime rate and adjust that rate at any time. However, it’s uncommon for a bank to adjust their prime rate unless the Bank of Canada adjusts its policy interest rate first.
Canadians planning to apply for a new mortgage or renew an existing mortgage are likely to keep a close eye on changes to prime rate because these changes will determine the interest rate they’ll be paying for their new mortgage.
Are you wondering how prime rate affects your new or existing mortgage? Keep reading to find out.
How does prime rate affect potential home buyers?
Prime rate is the benchmark banks use to set interest rates on financial products like lines of credit and mortgages. If you’re in the market to buy a home, mortgage rates will be directly tied to the prime rate of the financial institution at the time.
A rising prime rate means it’s more costly to get a mortgage because the interest charged on the loan will be higher, affecting not only your monthly mortgage payments but possibly the price of a house you can afford. Alternatively, lower rates can make homeownership more accessible because payments would be lower.
How does prime rate affect payments on fixed rate mortgages?
For individuals with fixed rate mortgages, their interest rate remains constant for the full term that they signed on for (the most common being 5 years at a time). This means that a fluctuation in prime rate will not impact them until their mortgage is up for renewal at the end of their mortgage term.
This is one of the major pros of fixed rate mortgages, since it makes it easier to weather economic storms (which is usually what’s happening when the prime rate increases a substantial amount). Though studies have shown that you’ll pay more interest over the course of a fixed rate mortgage than a variable one, sometimes this peace of mind and stability is worth the extra cost.
How does prime rate affect payments on variable rate mortgages?
Many people choose variable rate mortgages because the rate they’re offered is significantly lower than the rate they’re offered on a fixed mortgage. However, the rate on that fixed mortgage is guaranteed to remain constant for the duration of the term, while the rate charged on a variable mortgage fluctuates when the Canada prime rate changes.
There are 2 types of variable mortgages:
- variable mortgages with fixed payments, and
- variable mortgages with variable payments.
Variable mortgages with fixed payments
About 75% of Canadians with variable mortgages have fixed payments. This means that if you have a fixed payment of $800 biweekly and prime rate increases, your biweekly payment will remain at $800. What will change is the proportion of that payment that covers your interest vs. the proportion that pays down your principal.
For example, when you sign on to that mortgage and the $800 payment is established, $600 of that payment may be covering interest while $200 of that payment is paying down the principal of the loan. If interest rates increase, that ratio will shift, and you’ll be paying less of the principal per payment than you were before because a higher fraction of your payment is needed to cover interest charges.
If you were to reach what’s known as a "trigger point" where your interest payment equals or exceeds your total mortgage payment, and you’re no longer putting any money toward your principal, your lender may offer you a few options, such as:
- increasing your monthly payments,
- switching to a fixed rate mortgage,
- allowing you to make a lump sum payment,
- going into negative amortization,
- increasing your amortization term, or
- refinancing your mortgage.
Each mortgage will have a different trigger point, as laid out in your mortgage agreement.
Variable mortgages with variable payments
The other 25% of Canadians with variable mortgages have variable payments. For this group, a change in prime rate impacts the size of their mortgage payment.
For example, they may have a biweekly payment of $800 for a long time, but if the Bank of Canada increases its policy interest rate and their bank increases its prime rate, that $800 payment could become $850, $900, or even $1,000 very quickly. In some cases, that extra strain on your budget could be debilitating.
Has prime rate affected your mortgage payments?
Have the recent prime rate changes affected your mortgage payments or your mortgage rates?
Do you think a fixed mortgage is the way to go or do you think it’s better to take a risk on a variable rate?
We want to hear your thoughts! Let us know in the comments below.
FAQ
Are mortgages tied to Canada prime mortgage rate?
Yes. Canada’s official prime interest rate is an average of the prime rate being charged by each of the big banks. This is the rate banks use as a benchmark to determine how much interest will be charged on a new or variable mortgage.
What happens to my mortgage payments if prime rate goes up?
If prime rate goes up and you have a fixed mortgage, nothing will happen until it’s time to renew your mortgage. However, if prime rate goes up and you have a variable mortgage, either your payment will increase, or the portion of your payment that covers your interest will increase.
Who determines Canada’s prime interest rate?
Each week the Bank of Canada announces the country’s official prime interest rate, which is based on the average prime rate set by Canada’s 6 chartered banks. This is based on the overnight interest rate, which is revisited by the Bank of Canada every 1 or 2 months and is determined through various considerations, mostly revolving around curbing inflation.
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