January 9, 2012

Discussing Prime Rate

by CanEquity

How is Prime Rate in Canada Determined?

Canada’s prime rate is a guideline rate announced by the Bank of Canada (BoC) based on the country’s current economic tides. The BoC has slated eight times per fiscal year at which they may announce changes. They may also decide to hold the rate steady over a significant length of time.

Prime rate has an important effect on the economy. When rates fall out of line with the current cost of living, or inflation, the economy becomes in risk of bubbling. Therefore when inflation is on the rise it is usually in the best interest of the economy for the BoC to raise prime rate, making it more costly to borrow. This way spending slows and costs have time to adjust.

Reversely, in times of economic slowdown wherein no one is buying and inflation is in decline, it may be in the best interest of the economy for the BoC to lower prime rate and prompt a pick-up in the market.

Banks and lending institutions use prime rate to determine the rate they charge their top clients on loans or other financing products. Prime rate is not a minimum rate; minimums will vary depending on lender. Most lenders will stick close to prime rate to remain in line with the competition, but they may also drop or add basis points (one basis point is equal to 0.01%) based on current economic factors.

For example, when the market slows, banks may offer good clients variable rates with discounts below prime rate, such as a five year term with a prime minus 0.85% rate. At other times, when rates are low and the market is healthy, banks may offer prime plus a certain percentage point.

How does Prime Rate Affect Me?

At some point in every Canadian’s life there is a good chance that financing will need be borrowed to compensate a need or want. Whether this be a house, car, tuition or business loan, prime rate will affect the affordability of your financing and thus your purchase. Even if you are not the borrower, when rates are high or low the economy sees vast changes that trickle down to everyone living in the market.

How Does Prime Rate Affect My Mortgage Rate?

In Canada, though prime rate has some affect on all rates, two types of mortgage rates in particular are tied directly to it: variable and line of credit.

A variable rate mortgage is usually committed to in a closed term of three or five years. Banks and lending institutions will normally offer variable rates at prime rate minus a specific discount for the length of term, depending on the current market. Today prime rate is holding at 3%. The current variable rate offered through CanEquity Mortgages is 2.2%, or prime minus 80 basis points.

The line of credit mortgage is normally attributed a rate of prime plus a set number of basis points. Line of credit mortgages are drawn on the equity of a currently owned home, allowing the borrower to attain finances to apply toward the purchase of a second property, vacation, investment, or whatever they choose. For select terms this type of mortgage allows interest only payments, as well as opportunity to make re-payments at any time with no penalties.

Both the variable and line of credit mortgages will oscillate dependent on prime rate. This means that if prime rate rises, less of your payment will be going toward principal and more will be attributed to interest, thus your payments amounts could change in order to keep in line with your original amortization (the length of time in which your mortgage will pay out).

Your mortgage broker can explain these products to you in more detail, but having a good understanding of how prime rate works should help you in deciding which financing product is right for you. If the thought of oscillating payments causes concern, or you are not comfortable with the chance that prime rate might rise within your term, a fixed rate may be better suited. Though usually higher than variable rates, a fixed rate will stay the same through to the end of your term contract, regardless of the activity of prime rate.

This article was provided by CanEquity.com.