Understanding the Link Between Policy Rate and Prime Rate
The Canadian financial system relies on an interest rate transmission chain that runs from the Bank of Canada down to individual borrowers. At the top of this chain sits the policy rate (overnight rate target), which influences commercial banks' prime rate, which in turn determines the cost of variable-rate mortgage loans, home equity lines of credit, and many other credit products. This mechanical relationship is fundamental for any mortgage broker seeking to understand and explain variable product pricing to clients.
- Policy rate (overnight rate target)
- Rate set by the Bank of Canada at which major financial institutions lend funds to each other overnight on the money market. It serves as the benchmark for all short-term interest rates in the Canadian economy. The Bank announces it eight times per year.
- Prime rate
- Benchmark rate set by each financial institution for its best clients. It serves as the basis for calculating variable mortgage rates (expressed as prime ± X%), home equity lines of credit, and certain personal loans. Each bank may set its own prime rate.
The Transmission Mechanism in Detail
The prime rate has historically sat approximately 2.20 percentage points above the policy rate. This spread covers banks' operational costs, risk premium, and profit margin. For example, when the policy rate is at 4.50%, the typical prime rate is 6.70%. When the Bank of Canada announces a 0.25% increase or decrease, major banks generally adjust their prime rate by 0.25% on the same day or the next business day. The transmission is therefore nearly perfect in most cases, with a 1-to-1 ratio.
Variations Between Financial Institutions
While Canada's Big Six banks tend to align at the same prime rate, variations exist between institutions. Desjardins caisses in Quebec, regulated by the AMF rather than OSFI, set their own prime rate which may differ slightly. Some alternative and B lenders use different reference rates. It is therefore essential for brokers to compare not only the prime rate discount (for example, prime minus 0.80%) but also the prime rate itself of each institution to obtain the lowest effective rate for their client.
Impact on Mortgage Products
- Variable-rate mortgage (VRM): rate directly follows the prime rate. Monthly payment stays fixed, but the principal/interest split changes. During rate hikes, a larger portion goes to interest.
- Adjustable-rate mortgage (ARM): the monthly payment itself changes with each prime rate movement, increasing during hikes and decreasing during cuts.
- Home equity line of credit (HELOC): priced at prime rate plus a fixed spread (typically 0.50% to 1.00%). Interest-only payments fluctuate with prime.
- Fixed-rate mortgage: not directly affected by the prime rate. Its rate is determined by Government of Canada bond yields and the lender's credit spread.
- Hybrid mortgage: combines a fixed portion and a variable portion, the latter following the prime rate.
Variable Rate Expression: Prime ± X%
Variable rates are typically expressed relative to the prime rate. A rate of 'prime minus 0.80%' means that if prime is 6.70%, the effective rate is 5.90%. This discount (or sometimes a premium) is negotiated at the time of loan origination and remains fixed throughout the term, even as the prime rate fluctuates. The mortgage broker plays a crucial role in negotiating this discount: high volume of quality files and strong lender relationships enable better discounts for clients.
Practical Implications for Quebec Brokers
Understanding the mechanical link between the policy rate and prime rate enables brokers to take several strategic actions. First, calculate the precise impact of a rate change on a client's payment and prepare scenarios. Second, better negotiate discounts from lenders by understanding their cost structure. Third, clearly explain to clients why their payment changes (ARM) or why their amortization extends (VRM) when the policy rate rises. Fourth, anticipate rate movements by following Bank of Canada communications and adjust recommendations accordingly. The broker who masters this mechanism positions themselves as a trusted advisor capable of guiding clients through rate cycles.