Those with debt tied to the prime rate have reason to celebrate. The Bank of Canada has decided to once again to slash interest rates. After leaving interest rates frozen for nearly five years, the longest stretch in Canadian history, our central bank has already cut interest rates twice in 2015.
The Bank of Canada is struggling with the new reality of low oil prices, leading to a slowing economy. Bank of Canada Governor Stephen Poloz announced on Wednesday, July 15, the central bank was lowering the overnight lending to 0.5 percent from 0.75 percent, representing a 25 basis point rate cut. With the Canadian economy underperforming, this rate cut was expected and didn’t catch the markets off guard like the one in January 2015.
What is the Overnight Lending Rate?
The overnight lending rate is often referred to by the Bank of Canada as the key interest rate or key policy rate. This rate is important because it’s the rate the Bank of Canada uses to carry out monetary policy. The overnight lending rate is the rate financial institutions use to borrow and lend one-day funds between each other.
The Bank of Canada has a set schedule of eight announcements of interest rates per calendar year. The overnight lending rate is influenced by several factors including economic growth, inflation, exports, consumer debt, and more.
Why Interest Rates Matter
A change in the overnight lending rate causes a trickle-down effect felt throughout the Canadian economy. Although financial institutions set their own prime rate, it’s based on the overnight lending rate, plus a spread. For example, prime rate at most financial institutions today is 2.70 or 2.75 per cent (the overnight lending rate plus a 2.20 or 2.25 per cent spread).
With prime rate decreasing, the cost of borrowing for debt tied to prime rate decreases. Debt tied to prime rate includes variable rate mortgages, lines of credit, personal loans, car loans, RRSP loans, floating rate student loans, and some credit cards.
Who is Impacted by the Low Interest Rate Environment?
Low interest rates have a far-reaching impact on our economy. While low interest rates are beneficial to borrowers, they’re especially challenging for savers.
Borrowers with debt tied to prime rate are the first to benefit from lower interest rates. A lower prime rate means more of your money goes towards principal and less towards interest. If you’re a borrower, a prudent thing to do is pay down your debt. It’s hard to see how interest rates can get any lower (but never say never). Meanwhile, it’s a different story for savers, who are struggling to keep up with the rate of inflation.
The Bottom Line
With prime rate at a record low, there’s never been a better time to pay down debt. If you have debt tied to prime, you should take advantage and pay it down while interest rates remain low. Consider paying down debt with the highest interest rate first (usually credit card debt).