The prime rate is a critical factor influencing mortgage rates in Canada. It serves as a benchmark for variable lending products, including mortgages, lines of credit, and HELOCs. Fluctuations in the prime rate can significantly impact borrowing costs, directing and shaping interest rates in Canada and the financial decisions of homeowners and homebuyers.
Understanding how the prime rate works, how it is determined, and its effects on different mortgage solutions is essential for making wise choices about your financial circumstances. Whether you are pursuing long-term financial goals, selecting between fixed and variable mortgages, or adapting to changes in the Canadian mortgage market, understanding the prime rate can help you navigate market volatility and create a mortgage strategy that supports financial stability and homeownership goals.
What Is the Prime Rate?
The prime rate is the interest rate that major banks and financial institutions charge their most creditworthy customers. In Canada, the prime rate is closely linked to the Bank of Canada's (BoC) policy rate by a factor of 2.20% since 2015. The central bank’s policy rate is the benchmark that influences the rates banks set for their prime rate, directly affecting all their variable lending products.
Why the Bank of Canada Adjusts the Policy Rate
The Bank of Canada (BoC) adjusts its policy rate to balance economic growth, control inflation, and maintain financial stability, directly influencing the Canadian mortgage market and the broader economy. One of the primary reasons for these adjustments is to manage inflation, ensuring it stays within the target range of 1-3%. When inflation rises, the BoC increases the policy rate to discourage borrowing and spending, cooling the economy and reducing upward pressure on prices. Conversely, when inflation is below target or economic growth slows, the BoC lowers the rate to stimulate borrowing and spending, supporting financial stability and economic activity.
These policy rate changes also impact the value of the Canadian dollar. A higher rate strengthens the currency by attracting foreign investments, while a lower rate weakens it, making Canadian exports more competitive. This is particularly important given that the United States is Canada’s largest trading partner and adjustments in the US policy rate by the Federal Reserve (Fed) can create ripple effects that influence the BoC’s monetary decisions.
The policy rate adjustments also play a critical role in stabilizing the real estate market and addressing market volatility. Lower rates make credit more accessible, boosting affordability for mortgage products like variable-rate mortgages and supporting higher employment levels by encouraging business borrowing and expansion. Conversely, raising rates cools overheated markets, particularly the Canadian housing market, reducing speculative activity and preventing asset bubbles. The BoC’s actions reflect its broader economic outlook, influencing consumer and business confidence. Lower rates signal optimism, encouraging spending and investment, while higher rates promote caution, ensuring borrowing costs remain sustainable.
Additionally, the BoC monitors global economic trends and responds to shifts in US monetary policy. Due to its interconnectedness with the US, changes to the Federal Reserve’s policy rate can significantly impact Canada’s economy. Through these strategic adjustments, the BoC seeks to ensure that long-term financial goals are achievable for Canadian consumers while addressing short-term challenges in the Canadian mortgage market and maintaining overall market stability.
How the Prime Rate Directly Impacts Mortgage Rates
The prime rate directly affects certain mortgage types, including variable-rate mortgages (VRM), adjustable-rate mortgages (ARM), and home equity lines of credit (HELOC). Each of these mortgage solutions has unique characteristics and responds differently to changes in the prime rate, impacting monthly payments, affordability, and borrowing costs.
Variable-Rate Mortgages (VRM)
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Variable-rate mortgages are directly tied to the prime rate. When the prime rate rises, the interest rate on a VRM increases, leading to higher interest-carrying costs on monthly payments. VRMs have a fixed payment, which remains constant, but more goes toward interest.
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VRMs often offer lower rates and payments than fixed-rate mortgages during low interest rates, which can result in substantial savings for borrowers.
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Borrowers with VRMs must be prepared for fluctuations in interest rates, which can cause interest-carrying costs to increase unexpectedly. A VRM that’s reached its trigger point may leave the borrower with a larger balance than if the payment increased with each rate hike. This can make budgeting more challenging due to renewal payment shock, particularly during or after market volatility or rate hikes by the Bank of Canada.
Adjustable-Rate Mortgages (ARM)
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Adjustable-rate mortgages are variable mortgages where the interest rate and monthly payment adjust with each prime rate fluctuation.
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ARMs generally offer lower rates than fixed-rate mortgages, making them attractive for borrowers who want to save on their monthly payments if the prime rate is expected to be cut.
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Rate adjustments tied to the prime rate can cause monthly payments to increase significantly, especially during rate hikes. Still, unlike VRMs, they won’t add to your mortgage balance, as the payment will increase to compensate for rate changes.
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ARMs require borrowers to anticipate potential rate increases and adjust their budgets accordingly to manage future payment increases.
Home Equity Lines of Credit (HELOC)
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HELOCs are directly linked to the prime rate. Changes in the prime rate immediately impact the interest rate applied to the outstanding balance, causing payments to increase or decrease.
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HELOCs allow homeowners to borrow against their home equity as needed, but rising rates can make this borrowing facility more expensive.
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Borrowers using HELOCs must closely monitor rate trends and ensure they can manage higher payments if the prime rate increases. Self-control and budgeting are essential for those relying on HELOCs for large expenses or debt consolidation, as only the interest on the outstanding balance is due each month.
How the Prime Rate Indirectly Impacts Fixed Mortgage Rates
Fixed rates are unaffected by the prime rate and are instead based on its direction and broader market trends. However, fixed-rate mortgages are indirectly influenced by expectations of the Bank of Canada’s ability to manage inflation, divergence from the US Federal Reserve, and other economic risks, which impact the Government of Canada (GoC) bond yields.
Bond yields, particularly 5-year yields, are the benchmark for setting fixed mortgage rates. The Canadian 5-year bond yield is also heavily influenced by the 10-year US treasury bonds. Specifically, economic risks and growth in the US directly affect the direction of Canada’s economy.
Fixed rates are not tied to the prime rate, stabilizing borrowers' financial circumstances by locking an interest rate for the mortgage term. This makes them ideal during rising rates or economic uncertainty, offering predictable payments and shielding borrowers from rate volatility. Monitoring bond yield trends and policy rate adjustments can help borrowers time their decisions to secure favourable fixed rates.
Variable vs. Fixed Rates: How the Prime Rate Influences Your Decision
The prime rate plays a significant role in determining whether a fixed or variable mortgage is better for your financial needs. Fixed rates provide stability for risk-averse borrowers, while variable rates offer flexibility and potential savings for those comfortable navigating rate changes. The right choice depends on your financial situation and how you expect the prime rate to move.
Fixed Mortgages
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Fixed rates are unaffected by the prime rate, offering predictable payments.
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It is ideal for borrowers who value financial predictability during rising rates or economic uncertainty.
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Great for first-time homebuyers (FTHB) to get used to their mortgage and homeownership costs as they adjust to their new financial reality as a homeowner.
Variable Mortgages
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ARM payments increase or decrease as the prime rate changes, allowing potential savings when rates are low.
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VRM payments stay fixed as the prime rate changes, allowing you to reduce your mortgage amortization if rates go lower or stabilize your budget if rates go higher.
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Great for borrowers who can tolerate market fluctuations and may want to refinance or make prepayments.
Strategies to Manage Prime Rate Fluctuations
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Monitor Rate Trends: Keep an eye on Canada mortgage rate forecasts and updates from the Bank of Canada.
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Consider Hybrid Mortgages: A combination of fixed and variable rates can limit your renewal risk while balancing stability and flexibility.
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Work with a Mortgage Broker: An experienced mortgage expert can help you find the best mortgage rates and advise on the most suitable mortgage strategy based on current market conditions and your financial circumstances and needs.
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Get Pre-Approved: A mortgage preapproval locks in rates and helps you plan for future home purchases. Meanwhile, mortgage prequalification is best if rates are expected to go lower.
Mastering the Prime Rate: Your Key to Smart Mortgage Decisions
The prime rate is a cornerstone of the Canadian mortgage market, directly influencing affordability, mortgage rates alongside other borrowing costs, and the broader real estate market. Its fluctuations can determine the pricing of mortgages, making it a critical factor for homebuyers and homeowners alike. Understanding how the prime rate impacts fixed, variable and adjustable mortgage rates allows you to make smarter decisions that align with your long-term financial goals.
When looking ahead to 2025, the prime rate is expected to stabilize further depending on factors such as inflation trends, economic growth, and policy shifts by the Bank of Canada. As the Canadian economy continues its recovery, borrowers should prepare for the possibility of rate hikes, primarily due to economic divergence from the US or the possibility of tariffs becoming a reality. At the same time, those who act now can still take advantage of lower interest rates and favourable mortgage terms if potential monetary tightening is expected. Timing your mortgage decision can help you manage opportunity costs and secure financial stability.
Navigating the prime rate’s impact requires strategic planning. Whether buying your first home, refinancing an existing mortgage or approaching renewal, having a clear mortgage strategy is essential. Tools from nesto, such as our mortgage payment calculator or payment shock calculator, alongside customized insights from experienced mortgage experts, can help you mitigate the risks and optimize your most suitable mortgage solution.
For personalized guidance on finding the best mortgage rates in Canada, contact nesto mortgage experts today. With tailored strategies and expert advice, you can navigate mortgage rate forecasts and the Canadian housing market, secure a mortgage that suits your needs, and confidently achieve your financial goals.