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Greetings to all and a warm Welcome to New Subscribers.
Last week, the Bank of Canada raised interest rates .25% but our long term outlook looks to remain very reasonable.
From CBC News Interest Rates - a primer
What goes down must - when it comes to interest rates - eventually go up. And on June 30, 2004, another cycle of rising interest rates began in North America. For the first time in four years, the U.S. Federal Reserve Board raised rates.
The last time there had been any movement at all in American interest rates was a year earlier, when the Fed cut its benchmark rate by one-quarter of a percentage point to one per cent. Rates hadn't been that low since Father Knows Best ruled TV screens across the continent.
The movement of American rates is critical to what happens on this side of the border. According to the Bank of Canada:
"Interest rates in Canada are broadly determined by the level of interest rates in the United States, the relative inflation rates in both countries, and the relative stances of their monetary policies. A risk factor is also factored in. The result is that Canadian interest rates can be either higher or lower than U.S. rates but are never fully independent."
The Bank of Canada joined the upward cycle on Sept. 8, 2004, increasing its overnight loan rate by 0.25 percentage points to 2.25 per cent. The bank added another quarter of a percentage point to the rate on Oct. 19.
The increases were the first in almost a year-and-a-half.
The bank made it clear that as the economy continued to improve, there was only one way rates could go: up.
But a rapidly rising Canadian dollar started to take its toll on the economy. Growth on this side of the border slowed noticeably in the second half of 2004 and that got the attention of the Bank of Canada. It held off on further rate increases - until Sept. 7, 2005, when the rate went up another quarter of a percentage point to 2.75 per cent.
When the bank added a further quarter point increase to an even three per cent on Oct. 18, 2005, it strongly hinted that more rate hikes were on the way.
The bank issued a news release that contained the following statement:
"Given that the Canadian economy now appears to be operating at capacity, some further reduction of monetary stimulus will be required. [The Canadian economy] will continue to operate at about its production potential through 2007."
That's bankspeak for it's going to get more expensive to borrow money.
What is interest?
It is the cost of borrowing money - or the return on money you deposit in things like savings accounts, Guaranteed Investment Certificates and government bonds. There are two types of interest: simple and compound.
With simple interest, if your bank pays you four per cent on a five-year GIC, you will receive $4 per year for every $100 you invest.
With compound interest you receive interest on your interest. You will receive $4 the first year and approximately $4.16 in year two, $4.33 the third year, $4.50 in year four and $4.68 in year five. Your effective rate of interest becomes approximately 4.3 per cent.
Over that period of time, you hope inflation remains low. If it stays at two per cent, your real rate of return will be around two per cent on that GIC that pays four per cent. The real rate of return is what your money is really worth after you factor in how inflation erodes its buying power.
Does the Bank of Canada set interest rates?
Yes and no. The Bank of Canada sets the "Target for the overnight rate." The overnight rate is the interest rate that banks charge each other to cover their daily transactions. The target for the overnight rate is a half-percentage-point band.
If, for instance, that band is 4.25 per cent - 4.75 per cent, it means that banks will charge 4.75 per cent interest on money they lend to other banks and pay 4.25 per cent interest on money deposited by other banks.
The chartered banks use the overnight rate as a guide in setting their prime lending rate - the rate at which the bank's best customers can borrow money. When the central bank changes its overnight rate, it's sending a signal to the chartered banks that it wants them to change their prime lending rates. The banks will follow suit, because if the central bank raises its overnight rate and a bank leaves its lending rates unchanged, it will make less profit.
The Bank of Canada does not set mortgage rates or credit card rates. Mortgage rates and other loan rates usually move up and down with the prime lending rate. But those rates are not necessarily tied to the prime lending rate. Banks rely on the bond market to raise money for those kinds of loans. Interest rates on the bond market can move up or down more frequently than the prime rate because the bond market is far more sensitive to market fluctuations. Rates move when traders believe the central bank may be about to increase - or reduce - interest rates.
Credit card rates, on the other hand, hardly budge at all. Most cards carry an annual interest rate of around 19 per cent. Department store and gas cards are often around 28 per cent. The higher rate, according to the Canadian Bankers Association, is attributable to risk. A mortgage is a secured loan because the loan is backed up with a tangible asset: your house. Using a credit card is essentially taking out an unsecured loan because there is nothing physical used as security for the lender. In addition, the CBA says, credit cards are much more susceptible to fraud, which necessitates a higher interest rate.
What happens when rates go up?
It costs more to borrow money. This doesn't have much of an impact on day-to-day buying decisions. But if you're in the market for a house, you might think twice about buying as rates rise. For instance, if you need a $200,000 mortgage - which is not uncommon now that you can buy a home with essentially no down payment - you would be paying $1,163.21 every month in principal and interest for 25 years, if your mortgage interest rate was five per cent.
But if that rate is just one percentage point higher, your payments would be $1,279.62 per month. And that doesn't include property taxes. Bump the rate to seven per cent and your payments are just over $1,400 a month. Might be enough to make you think twice about buying.
And if you don't buy, then those big box hardware stores might not see as much of you because you won't be doing all those renovations to that house. Same goes for the furniture stores that wanted to sell you that entertainment unit for the new home theatre you were thinking of installing.
Another problem with higher rates: if you have a line of credit that's secured by the equity in your home, it's going to cost more to carry that debt.
On the other hand, if you've paid off your mortgage and have a whack of cash lying around, higher rates mean the bank will pay you more to let your money sit with them in savings accounts or GICs.
The central bank moves to higher rates when it believes the economy is in danger of growing too rapidly. Rapid economic growth could cause a cycle of rising prices and wages. The central bank wants that growth to be moderate, so inflationary pressures are kept in check.
What happens when rates go down?
The cost of borrowing goes down, except, usually, for credit cards. Lower rates are a signal from the central bank that it's worried that the economy is weakening and people aren't buying enough big-ticket items. When people stop buying cars and homes, a lot of people are in danger of losing their jobs.
Do changes in U.S. rates automatically signal changes in Canadian rates?
Usually, but not necessarily. When interest rates are lower in Canada than in the United States, the value of the Canadian dollar usually drops. Foreign investors will usually park their money where they can get a higher rate of return. They'll ship it to Canada as rates rise above American rates, which creates a demand for Canadian dollars, which pushes up their value.
The Canadian economy also does not necessarily follow the American economy as it expands - or contracts. When the Canadian economy is doing better than the American economy and inflation remains under control, the central bank may not have to follow every move the American central bank makes.
When are interest rates set in Canada?
The Bank of Canada sets rates eight times a year - in late January, early March, mid April, late May, mid July, early September, mid October and early December.
The Bank retains the option of taking action between fixed dates, but only under extraordinary circumstances.
The U.S. Federal Reserve also sets rates eight times a year. The Bank of England sets rates 12 times a year.
(October 25, 2005)
I trust this information will come in handy and help you to stay informed.
One Small Saving on your Interest Rate will be worth Thousands! in the Long Term.
Feel Free to call anytime…
Dan Heon
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