According to a recent statement by the Canadian Bankers Association, many Canadian consumers are confused by the relationship between the central bank and commercial banks.
The Bank of Canada's rates have very little to do with mortgage rates, the association has explained:
"The Bank of Canada does not set consumer interest rates. While the Bank of Canada rate does influence the pricing of very short-term commercial credit, this is actually less than one per cent of funding for banks," said Maura Drew-Lytle, spokeswoman for the association.
"Longer-term fixed rates are more affected by factors ... such as prices in the bond market, the costs of longer-term deposits, and the competition for funds in the financial markets."
Quite simply, interest is the cost of money. The rate of interest is the cost of using someone else's money. When it comes to interest rates, Canadians are pulled in two directions: people who save and invest money expect a good return on their investments, or people who borrow money to buy homes, cars, businesses etc, want the lowest possible interest rates.
Many people think that the interest rate that banks charge for fixed-rate mortgages and loans is driven by the Bank of Canada's overnight rate. In fact, this is not true. While the Bank of Canada rate does influence the pricing of very short-term commercial credit, longer-term fixed rates are more affected by factors other than the Bank of Canada Rate, such as prices in the bond market, the costs of longer-term deposits, and generally the competition for funds in the financial markets.
The Bank of Canada does not lend money to banks to loan out in the form of long-term mortgages. The money borrowed from the Bank of Canada pays for daily transactions and closing costs between major banks.
Money for mortgages comes from consumer deposits and bank investments. Mortgage rates are based on a number of variables. Banks must balance the amount they charge in interest with the amount they pay on consumer savings accounts. As the price paid on account interest rises, mortgage rates will also rise.
Banks also use other investments as yardsticks for mortgage rates. If a secure investment, such as a Canada Savings Bond, is paying three per cent annually, an investment such as a mortgage must be priced higher to cover for the risks involved and to ensure that the bank makes a profit.
Four facts on Bank Lending that you should be aware of:
- Banks represent approximately half of the business lending market and one-quarter of the overall business financing market in Canada.
- Bank lending to consumers increased year-over-year by 7.9% for mortgage credit and 15.8% for non-mortgage credit (2009).
- Banks are continuing to work to make credit available to credit-worthy businesses in Canada, including through close cooperation with Export Development Canada (EDC) and Business Development Bank of Canada (BDC) through the government's Business Credit Availability Program (BCAP).
- The Bank of Canada rate represents less than one per cent of bank funding and there are a range of other factors that more directly influence the pricing of consumer lending.
According to Steve Foerster, a professor of finance with the Richard Ivey School of Business at the University of Western Ontario, inflation also plays a key role.
"If I anticipate higher inflation, then I am going to demand a higher rate. If one has to bet in terms of the direction of interest rates, it would be a good bet that rates are going to go up. More recent indications are that it could be sooner rather than later."
The question many Canadians are asking is whether as a saver or investor are they better off when interest rates are high.
The answer is that not necessarily. You have to figure out what you're really earning after inflation (ongoing increase in the price of goods and services).
For example: if interest rates are 18% and inflation is 15%, you're really only earning 3% (before taxes). But if interest rates are 6% and inflation is 1%, you are earning 5% (before taxes).
So you see, sometimes you're better off to invest when interest rates and inflation are low. The key is to always keep an eye on the "Big Picture".
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