As part of its quantitative tightening plan to decrease Canada’s inflation rate to 2%, the Bank of Canada recently increased its policy interest rate by 50 basis points (0.50%).
In response, almost all major banks and lenders in Canada have adjusted their prime rates accordingly, increasing interest rates across the board.
This marks the seventh consecutive increase to the Bank of Canada’s target overnight rate in 2022 and has left many Canadians wondering just how high Canada’s prime rate can go.
Today, I’ll explain a bit more about what the prime rate is, how it can affect your personal finances, and offer some projections based on historical prime rate data.
WHAT IS THE CURRENT PRIME RATE IN CANADA?
On December 7, 2022, the Bank of Canada increased the target overnight rate from 3.75% to 4.25%. This 50-basis point increase imposed by the Bank of Canada has caused Canada’s prime rate to increase from 5.95% to 6.45%.
Over the past year, Canadians have faced increasing interest rates as the government tries to rein in the inflation rate. As the Bank of Canada increases its rates, the prime rate set by banking institutions also increases.
BoC POLICY INTEREST RATE VS. BANKING PRIME RATE
It’s important to understand the difference between the Bank of Canada’s policy interest rate and the prime rate set by banks and lenders. While the two rates are closely correlated, they’re also different.
The Bank of Canada is the country’s central bank. Commercial banks such as RBC, TD Bank, and others all borrow money from the central bank to balance out their cash reserves. Whenever banks borrow money from the central bank, the funds are subject to the Bank of Canada’s policy interest rate (also known as the target overnight rate).
Of course, commercial banks need to make a profit as well. So, commercial banks set their prime rate 2-3% higher than the central bank’s policy rate. This is why the current prime rate set by banks is 6.45%, while the central bank’s policy interest rate is 4.25%.
HOW HIGH CAN THE PRIME RATE GO?
As the Bank of Canada’s policy rate increases or decreases, the prime rate imposed by banks will be adjusted accordingly. Since March 17, 2020, the prime rate has steadily increased from its low point of 2.95% to the current 6.45% prime rate. According to Wowa’s historical prime rate chart, the last time that the prime rate was this high was in April 2001.
Just how high can Canada’s prime rate go, though? Canadians could potentially see even more increases to the prime rate in 2023.
In November, RBC predicted the most recent 50-point increase to the prime rate. The same report also predicts that the central bank will continue increasing its policy rate by 25 to 50 points at each meeting. However, this projection also predicts that the interest rate hikes may begin to cool down by March or April.
Based on this projection, Canadians could potentially see the prime rate increase to 6.95% (and possibly higher) in early 2023.
That being said, these projections are purely hypothetical, as they’re based on multiple economic factors. For the worst-case scenario, we can turn to historical data. The highest prime rate that’s ever been seen in Canadian history was 22.75% in August 1981. It would be devastating for many families if prime rates were to get that high today.
Hopefully, things won’t get that bad, as Canada’s labour market still looks quite strong. The government’s monetary policy of all these rate hikes might get inflation under control and eliminate the need to keep increasing the overnight rates. The Bank of Canada has also dropped hints that they might pause the rate hikes next year.
WHY DOES THE BANK OF CANADA INCREASE ITS POLICY RATE?
Although inflation is down from its peak of 8.1% in June 2022, it’s still at a record high. According to the latest data from Statistics Canada, the consumer price index (inflation rate) in Canada is currently 6.9%.
One of the main reasons why the central bank increases its policy rate (thus causing the prime rate to increase) is to combat inflation. When interest rates are higher, there is less liquidity in the market, as borrowers tend to borrow less. This allows the central bank to tighten its balance sheets, which can slow or decrease inflation.
HOW A HIGH PRIME RATE COULD AFFECT CANADIANS
As prime rates continue to increase, borrowing money becomes more expensive. Individuals trying to get approved for a mortgage, a small business loan, or auto financing will have to take out higher-interest loans. This, in turn, is causing many Canadians to rethink their decision to buy a new house, finance a new car, or start a business.
Higher prime rates could also dramatically affect consumers with variable-interest mortgages or those that are up for refinancing. It would cause much higher mortgage payments, which could lead to more foreclosures or downsizing of homes.
Higher prime rates also affect consumers as credit card companies increase their adjustable interest rates. This means that individuals carrying a credit card balance could end up paying even more.
Depending on how the Canadian economy responds to the central bank’s recent rate increases, we could see the prime rate continue increasing in early 2023.
Hopefully, it will cool down by mid to late 2023, but the verdict is still out, and it all depends on how the Bank of Canada decides to move forward with its current quantitative tightening policy.
Christopher Liew is a CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers on his Wealth Awesome website.
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