What happens when interest rates rise in Canada

On July 12th, 2023, the Bank of Canada (BoC) announced it was raising its interest rate to 5%. This comes only weeks after its early June decision to raise it to 4.75%. This brings borrowing costs to a level Canadians have not seen in 22 years. 

Why is this happening?

The COVID-19 pandemic changed the economic landscape in 2020. To boost the economy, the Bank of Canada lowered its policy interest rate to 0.25%.

However, since January 2022, the BoC raised its policy interest rate by 4.75%. This is an attempt to slow down high inflation.

In June 2022, inflation was the highest it’s been in almost 40 years. Although it has slowed in the months since, it remains high. Too high for the BoC, that hopes it will come down to its 2% inflation rate target.

Let’s look more closely at how policy interest rates work and how they can affect your finances.

What is a policy interest rate?

The policy interest rate is set by a country’s central bank, such as the Bank of Canada. Its policy rate serves as a reference point for the rates banks charge to consumers.

These rates affect the interest rates you pay on:

• your mortgage,
• your home equity line of credit, and
• other types of credit.

What is the prime interest rate?

The prime interest rate is based on the Bank of Canada’s policy interest rate. It is set by large financial institutions.

When you apply for a loan with a variable interest rate, your lender will give you one that’s tied to the bank’s prime rate. If the policy interest rate in Canada goes up, so does the rate of interest you pay.

In response to the recent policy interest rate hike, Canadian financial institutions increased the prime rate. This increase could make borrowing more expensive and impact your spending and investment decisions.

What do rate increases mean for homeowners?

Are you planning on renewing your mortgage, buying a home or taking out a loan?  Ask yourself, “Can I handle that debt or that new loan at a higher interest rate than I’m receiving today?”

• Fixed-rate mortgage

If you’re renewing your fixed-rate mortgage soon, higher interest rates could increase your monthly payments. This increase could have an important impact on your budget especially if:

• your new amortization period is short, and
• the balance on the mortgage at the time of renewal is substantial.

For a precise indication of how your mortgage payments could change, contact your mortgage broker or lender.

• Variable-rate mortgage

If you have a variable-rate mortgage, recent rate increases will affect you differently. Your payments probably increased, to mirror the prime rates.

• Stress test now harder for some homebuyers

Are you buying a new home? Federal rules require you to pass a stress test if you’re making a down payment of less than 20%.

The stress test requires borrowers to prove they can make mortgage payments at whichever rate is greater:

• the rate offered by their lender, or
• the 5-year fixed rate set by the Bank of Canada.

The recent increases will likely make the stress test more challenging for some homebuyers.

What do rate increases mean for first-time home buyers and tenants?

For prospective buyers looking to buy their first home, even a slight increase in interest rates can have a significant impact over time.

The latest increase pushed the prospect of ownership for some first-time buyers even further out of reach. Interest rates are the highest they’ve been since April 2001.

Rising rates also affect the rental market, as higher mortgage costs eventually impact tenants. The cost is often passed down to the tenant through rent increases.

What do higher interest rates mean for savings accounts and GICs?

When interest rates go up, so do consumers' expectations for interest rates on savings accounts. Recent hikes may mean slightly higher rates on savings accounts and guaranteed investment certificates (GICs) down the road. Financial institutions aren’t obligated to raise savings account interest in proportion to borrowing interest rates, but competitive pressures may eventually result in a rise.

Can rising interest rates cause a recession?

Rapid increases in interest rates can often lead to a recession. Since 1961, there have been three instances where the BoC raised interest rates rapidly to slow down inflation. It led to a recession every time.

So it’s no surprise that most Canadians think a recession is on the horizon. However, the economy is doing better than what forecasters predicted, and the job market is perceived by workers as strong.

Despite the positive economic data, consumers remain cautious. Many Canadians are expected to curb their spending on travel, entertainment, and social activities.

How to prepare for an interest rate rise?

The steady hike in rates since January 2022 have changed the landscape for those taking out a loan. Especially for homeowners who’ve enjoyed years of historically low rates. Economists are divided as to whether more hikes are in the cards. Whatever the economic forecast, it’s never a bad idea to:

• Make a budget and stick to it as best you can.
• Build an emergency fund for hard-to-predict expenses.
• Make a financial roadmap with the help of an advisor. When life changes, remember to update it.
• Try to limit your spending and chip away at your debt. That way, any rate hikes have the least possible negative impact on your finances.

Read more:

• Inflation: What it means and how to protect yourself
• What do you do when the stock market drops?
  
• What is a recession and what does it mean for you?