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In a move that surprised no one, the Bank of Canada (BoC) increased its overnight interest rate by 0.25%, to a total of 1.75%. This marks the fifth interest rate hike since mid-2017. Economists believe that this isn’t the last interest rate hike we’ll see in the near future either.
Of course, if you watch the news, you will inevitably see a number of sensationalist articles, some which paint the situation as grim, while others rejoice and praise the economy. This of course raises a question: is the latest interest rate hike something to be worried about? How will it affect me personally?
Why does the Bank of Canada increase interest rates?
One of the main responsibilities for the BoC is to keep the economy stable, by maintaining inflation low (between 1 – 3 percent), manageable and predictable. Its main tool to achieve that goal is its ability to change overnight interest rates.
When the economy is doing well, the BoC increase its interest rates in order to lower the amount that people spend and how much personal debt they acquire. This has the effect of stabilizing housing costs, since it becomes more difficult to afford a mortgage. It may seem strange that a central bank would want people to borrow less money, but when credit is cheap, and people confidently borrow to buy homes and consumer goods, prices skyrocket, and inflation goes up.
On the other hand, when the economy is slow, the BoC will lower its interest rates, in order to encourage spending, and get the economy moving again.
Why are BoC’s interest rate hikes so influential?
When a person or a corporation needs money, a bank may be willing to lend it to them – for a price. That price is called interest, and it’s the main way in which a bank makes money.
The total amount of money a bank has at any given point changes daily, depending on activities such as customers withdrawing or depositing money, new loans being approved, etc. A bank needs to have a certain amount of money available in order to function properly. So if a bank’s money supply is low, they need to borrow money from other banks. Just like regular people, if a bank borrows money from another bank, they must also pay interest on what they borrowed.
As Canada’s central bank, the Bank of Canada is a bank’s bank. It does not lend money to individuals; it lends money to banks. Whenever a bank needs a loan, just like regular people, it needs to meet certain requirement before it’s approved. Since the BoC typically offers the lowest interest rates a bank can borrow from, banks will try to qualify for loans from the Bank of Canada to get the money they need.
Since the BoC has the ability to change its interest rates, every time it increases them, it makes it more expensive for banks to borrow money. In order to compensate, banks also raise their own interest rates. On the other side of the coin, when the BoC decreases its interest rates, banks also tend to lower their interest rates.
This influence the BoC has on banking institutions is the main reason why we see a surge of headlines every time it adjusts its overnight interest rates. While a 0.25% change in interest rates may seem low, the additional money you pay in interest adds up, especially when you’re dealing with a 20 – 25 year mortgage.
Should I be worried by the latest increase in interest rates?
The short answer is: it depends.
The immediate effect of a BoC interest rate hike is that borrowing money will be more expensive.
If you already have a fixed rate mortgage, your monthly payments will see no change from the latest hike. But if you have a variable rate mortgage, your monthly payments will go up. Every time there’s a 0.25% increase, your monthly payments goes up by around $13 a month per $100,000 in mortgage debt. So if you have a $600,000 variable-rate mortgage, your monthly payment will increase by around $78. First time buyers will be particularly affected, since it will be even more difficult for them to qualify for mortgage after the latest hike.
Because people need a place to live, there will likely be an ever-greater number of people looking to rent as interest rates increase. If you’re a landlord, or a real estate investor looking to purchase an investment property, this could be great news. As the demand for rental units increases, rent prices should increase as well, and any extra expense in securing a loan with higher interest rates will likely be offset by an increase in rents.