Why is the Bank of Canada increasing your borrowing costs?

Why is the Bank of Canada increasing your borrowing costs?

The Bank of Canada is raising rates toward a “neutral interest rate” and this will lead to higher borrowing costs, and less money in your wallet. In this article you will learn:

  • What the neutral rate is.

  • Why it’s been so low.

  • The impact of rising rates and its impact on you.

What is a “Neutral interest rate”?

The Bank of Canada has said they want to raise the Bank Rate toward a “Neutral Interest Rate”. Most people have heard of the Prime Rate and Mortgage Rates but what is a Bank Rate? The Bank Rate is the rate at which the Bank of Canada lends to Canadian Banks, for example RBC and TD Canada Trust. A neutral interest rate is a range of values for the Bank Rate (also known as the Target Overnight Interest Rate) that is good for maintaining a steady economy when the economy is performing well and inflation is around 2%. This range is between 2.5% to 3.5%. The overnight rate is used to either boost or slow down the economy. Setting the rate below the neutral range is like pushing the accelerator on the economy and setting it above the neutral range is like putting the brakes on the economy. Generally, the Bank Rate should be higher than inflation because otherwise Canadian Banks are essentially being paid to borrow money.

Why are rates at historical lows?

Prior to the financial crisis of 2008, the Bank of Canada’s target overnight rate ranged between 2-6%. Once the financial crisis happened, all of that changed. In order to protect the Canadian economy from The Great Recession, the Bank of Canada reduced the Bank Rate to a historical low of 0.25% in order to boost the economy. They began raising the overnight rate gradually as the economy recovered up until 2015 when the price of oil plummeted and caused major problems in Alberta’s oil industry. To help Alberta, the Bank of Canada dialed the overnight rate down to 0.5%.

A knock-on effect of the incredibly low Bank Rate has been mortgage rates lower than anyone has ever seen before in Canada’s history, which in turn has boosted real estate prices across the country to record highs because low rates increase how much homebuyer’s can borrow. Unfortunately, this increase in homebuying budgets will evaporate if, as expected, rates are eventually raised toward the normal or neutral range.

The impact of rates rising toward a neutral rate

The Bank of Canada has consistently said that it hopes to raise rates into the target neutral rate range- between 2.5 and 3.5%. This means that interest rates could rise as much as 2% in the next couple of years. An interest rate rise of this magnitude combined with the new mortgage rules reduces what buyers can pay for a home by 20%. For example, in 2016 if a buyer could afford a $500,000 condo, in the future the same buyer would only be able to spend $400,000 to buy a home.

What does this mean for homebuyers?

Firstly, the rise in rates reduces your home buying budget and this can make a huge difference in size, location, and overall quality of the home that you’re able to purchase.

Secondly, if you own a home and your budget is tight, a rise in rates can mean the difference between just barely making monthly payments, to being forced to sell your home and become a renter. If you are one of the many people who are just able to fit their mortgage payments within their monthly budget, then it is incredibly important for you to begin preparing financially for a gradual rise in rates. For example, you may have the option to refinance to lower your monthly payments.

Conclusion

The increase in rates toward a neutral range may seem logical and inevitable to economists, but for the average Canadian it may be a huge surprise and could cause serious financial hardship. We recommend you take stock of your monthly expenses and plan for a 2% increase in interest costs. See if you need to meet with a financial advisor to figure out how to reduce your monthly expenses. As well, when shopping for a home, you will need to adjust your expected purchase price downward by about 20%.


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 Mo Aghelnejad
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