Friday, July 5, 2024 / by Teresa Pileggi
What Is a Prime Rate In Real Estate?
What Is a Prime Rate In Real Estate?
As an aspiring real estate investor, you might have met terms like prime interest rate, prime lending rate, or prime rate during your research. As complicated as it might sound, the prime interest rate serves as a crucial financial metric that impacts several economic factors in Canada. From consumer loans to mortgages and business financing, this base rate determines how much financial institutions charge their borrowers. So, what is the prime rate, and how does it work? If you are planning to get your foot into the housing market, here is what you should know about the prime rate in Canada, how it is determined, and its impacts on borrowers and lenders.
What Is the Prime Rate in Canadian Real Estate?
Prime rate or prime interest rate has been on the headlines for quite some time in Canada.
This is especially after the Bank of Canada (BoC) raised its key interest rate or overnight rate multiple times since March 2022. Although the bank cannot control the prime rate directly, changing its overnight rate significantly influences the prime rate, and the impact is transmitted to other financial institutions and borrowers across the economy.
The prime rate, therefore, is the best interest rate that commercial banks in Canada charge their most creditworthy customers with a solid financial standing. These customers can be individuals with more money and assets or large corporations with higher credit ratings.
Since such customers have a lower risk of default, banks usually charge them a prime rate lower than the market interest rate.
The prime rate also acts as a base rate, benchmark, or starting point for other loans and credit products like personal loans, credit cards, and mortgages. Commercial banks and other lenders add a margin to the prime rate when lending money to determine their loan interest rate. A margin in the real estate market represents the difference between the prime rate (index) and the interest rate offered.
Difference Between the Prime Rate and Overnight Rate
Prime and overnight rates are the two most significant factors affecting the lending
market. However, these rates are set differently, even though one depends on the other. For instance, the Bank of Canada sets the overnight interest rate (key interest rate). In contrast, financial institutions set the prime rate. As such, financial institutions usually change their prime rate with the same amount the Bank of Canada changes the overnight rate.
For example, when the Bank of Canada raised its overnight rate by 25 basis points in July
2023, from 4.75% to 5%, financial institutions also raised their prime rate by 25 basis points
from 6.95% to 7.2%. It is also vital to note that the prime rate is usually higher than the overnight rate.
How Is Prime Rate Set?
From the above illustration, it is clear that the prime rate is closely linked to the bank of Canada's monetary decisions on its key interest rate (policy interest rate). That is because when the central bank changes its key interest rate, it gives a direction in which other financial institutions should change their short-term interest rates. During scheduled announcements, the Bank of Canada also reviews and adjusts the policy interest rate eight times a year. The announcements are then followed by changes in prime rate the following day.
The central bank's primary purpose in adjusting or holding the current policy interest rate is to promote economic stability. Several factors that the bank considers when reviewing the policy rate include:
? Inflation: The Bank of Canada strives to keep inflation within a manageable target
rate of 2%. Therefore, an increase in inflation influences the central bank to increase
the policy rate, which significantly increases the prime rate.
? Economic growth: The Bank of Canada monitors economic indicators like gross
Domestic product (GDP), employment rate, and consumer spending. The central bank lowers its policy rate to encourage borrowing and spending to promote economic growth.
? Financial stability: To maintain financial stability, the central bank also monitors the banking system's health and ensures that other financial markets run smoothly. It does this by adjusting the policy rate, which influences lending practices and
borrowing costs.
How The Prime Rate Impacts Mortgage Rates in Canada
When the Bank of Canada reviews and adjusts the overnight rate, the impact is transmitted through the financial system to the prime rate. It influences other rates, including mortgage
rates. Here is a breakdown of how the prime rate affects mortgage rates in Canada.
1. Prime Rate Vs. Variable-Rate Mortgages
Variable-rate mortgages are home loans whose interest rates can change anytime during the mortgage term. The interest rates on variable-rate mortgages are usually expressed as the prime rate minus or plus a certain percentage. For example, they can be advertised as prime plus 0.5%.
Changes in the prime rate significantly affect the variable mortgage rate. For instance, when the prime rate increases, variable-rate mortgages also increase, which results in lenders increasing monthly mortgage payments for borrowers. Conversely, when the prime rate decreases, variable-rate mortgages decrease, and borrowers can make lower monthly payments.
2. Prime Rate Vs. Fixed-Rate Mortgages
Fixed-rate mortgages are those whose interest rates remain constant for the entire loan term.
Changes in the prime rate less directly influence these mortgage rates. However, the overall lending market can affect changes.
Some of the primary factors that can cause changes in fixed-rate mortgages include:
? Market expectations: If the mortgage facilities expect the Bank of Canada to
increase the overnight rate in the future, they can increase their fixed-rate mortgages in anticipation.
? Bond yields: Fixed-rate mortgages can increase when bond yields rise. Several
factors that influence bond yields include inflation, monetary policy signals from the
Bank of Canada, and economic growth forecasts.
The Bottom Line
The prime rate is a cornerstone of the Canadian real estate market and other economic factors. Understanding how this rate works and impacts mortgage rates is essential for borrowers and lenders. Therefore, before entering the housing market, one should learn more about the Bank of Canada's policy rate decisions and prime rate history.
As an aspiring real estate investor, you might have met terms like prime interest rate, prime lending rate, or prime rate during your research. As complicated as it might sound, the prime interest rate serves as a crucial financial metric that impacts several economic factors in Canada. From consumer loans to mortgages and business financing, this base rate determines how much financial institutions charge their borrowers. So, what is the prime rate, and how does it work? If you are planning to get your foot into the housing market, here is what you should know about the prime rate in Canada, how it is determined, and its impacts on borrowers and lenders.
What Is the Prime Rate in Canadian Real Estate?
Prime rate or prime interest rate has been on the headlines for quite some time in Canada.
This is especially after the Bank of Canada (BoC) raised its key interest rate or overnight rate multiple times since March 2022. Although the bank cannot control the prime rate directly, changing its overnight rate significantly influences the prime rate, and the impact is transmitted to other financial institutions and borrowers across the economy.
The prime rate, therefore, is the best interest rate that commercial banks in Canada charge their most creditworthy customers with a solid financial standing. These customers can be individuals with more money and assets or large corporations with higher credit ratings.
Since such customers have a lower risk of default, banks usually charge them a prime rate lower than the market interest rate.
The prime rate also acts as a base rate, benchmark, or starting point for other loans and credit products like personal loans, credit cards, and mortgages. Commercial banks and other lenders add a margin to the prime rate when lending money to determine their loan interest rate. A margin in the real estate market represents the difference between the prime rate (index) and the interest rate offered.
Difference Between the Prime Rate and Overnight Rate
Prime and overnight rates are the two most significant factors affecting the lending
market. However, these rates are set differently, even though one depends on the other. For instance, the Bank of Canada sets the overnight interest rate (key interest rate). In contrast, financial institutions set the prime rate. As such, financial institutions usually change their prime rate with the same amount the Bank of Canada changes the overnight rate.
For example, when the Bank of Canada raised its overnight rate by 25 basis points in July
2023, from 4.75% to 5%, financial institutions also raised their prime rate by 25 basis points
from 6.95% to 7.2%. It is also vital to note that the prime rate is usually higher than the overnight rate.
How Is Prime Rate Set?
From the above illustration, it is clear that the prime rate is closely linked to the bank of Canada's monetary decisions on its key interest rate (policy interest rate). That is because when the central bank changes its key interest rate, it gives a direction in which other financial institutions should change their short-term interest rates. During scheduled announcements, the Bank of Canada also reviews and adjusts the policy interest rate eight times a year. The announcements are then followed by changes in prime rate the following day.
The central bank's primary purpose in adjusting or holding the current policy interest rate is to promote economic stability. Several factors that the bank considers when reviewing the policy rate include:
? Inflation: The Bank of Canada strives to keep inflation within a manageable target
rate of 2%. Therefore, an increase in inflation influences the central bank to increase
the policy rate, which significantly increases the prime rate.
? Economic growth: The Bank of Canada monitors economic indicators like gross
Domestic product (GDP), employment rate, and consumer spending. The central bank lowers its policy rate to encourage borrowing and spending to promote economic growth.
? Financial stability: To maintain financial stability, the central bank also monitors the banking system's health and ensures that other financial markets run smoothly. It does this by adjusting the policy rate, which influences lending practices and
borrowing costs.
How The Prime Rate Impacts Mortgage Rates in Canada
When the Bank of Canada reviews and adjusts the overnight rate, the impact is transmitted through the financial system to the prime rate. It influences other rates, including mortgage
rates. Here is a breakdown of how the prime rate affects mortgage rates in Canada.
1. Prime Rate Vs. Variable-Rate Mortgages
Variable-rate mortgages are home loans whose interest rates can change anytime during the mortgage term. The interest rates on variable-rate mortgages are usually expressed as the prime rate minus or plus a certain percentage. For example, they can be advertised as prime plus 0.5%.
Changes in the prime rate significantly affect the variable mortgage rate. For instance, when the prime rate increases, variable-rate mortgages also increase, which results in lenders increasing monthly mortgage payments for borrowers. Conversely, when the prime rate decreases, variable-rate mortgages decrease, and borrowers can make lower monthly payments.
2. Prime Rate Vs. Fixed-Rate Mortgages
Fixed-rate mortgages are those whose interest rates remain constant for the entire loan term.
Changes in the prime rate less directly influence these mortgage rates. However, the overall lending market can affect changes.
Some of the primary factors that can cause changes in fixed-rate mortgages include:
? Market expectations: If the mortgage facilities expect the Bank of Canada to
increase the overnight rate in the future, they can increase their fixed-rate mortgages in anticipation.
? Bond yields: Fixed-rate mortgages can increase when bond yields rise. Several
factors that influence bond yields include inflation, monetary policy signals from the
Bank of Canada, and economic growth forecasts.
The Bottom Line
The prime rate is a cornerstone of the Canadian real estate market and other economic factors. Understanding how this rate works and impacts mortgage rates is essential for borrowers and lenders. Therefore, before entering the housing market, one should learn more about the Bank of Canada's policy rate decisions and prime rate history.
