What You Need to Know about the Bank of Canada Rate When Buying a House
You may have read that it’s useful to be aware of the Bank of Canada (BOC) rate when you’re thinking about buying a home. This is true. But there’s quite a long and complicated route from the BOC rate to the price of the home you want to buy, bringing in the economy, inflation and history along the way. Here’s how we explain it.
The BOC rate
The Bank of Canada (BOC) rate, also known as the benchmark interest rate, the base interest rate, the policy rate and the key interest rate, is a Canada-wide interest rate set by the BOC that governs the interest rates that financial institutions use as a base rate for lending and borrowing funds. The interest rates on your bank overdraft, your mortgage and your credit card balance (if you don’t pay it off in full) are all related to the BOC rate.
This benchmark rate is the BOC’s main tool to balance the economy by controlling the money supply and subsequently keeping inflation in check. By adjusting the benchmark rate, they hope to either encourage people to borrow more money and buy more goods by lowering the interest rate or to encourage them to save or spend less by raising the interest rate [1,2].
The BOC rate and inflation
The BOC makes its decisions based on the growth of the Consumer Price Index (CPI) from Statistics Canada. This is calculated from the price of a monthly “basket” of goods and services typically used by Canadians. It represents a broad picture of consumer spending across Canada . However, the prices determined for and the weight assigned to each item may not reflect real prices or proportions. For example, the amount allocated for rent is mainly based on the government-regulated rent prices and not on actual market prices. Also since the basket reflects the general population (i.e. both homeowners who have long since paid off their homes and younger millennials and Gen Z), it may be far from the real spending patterns of any one age group.
Introduced in 1991, the inflation-control target sets a range of 1% – 3% as the ideal range for annual inflation, with the midpoint of 2% being the common target rate. This range is reviewed regularly with the latest review being in October 2016. As a result of that review, the BOC and the federal government decided to hold the inflation-target rate steady at 2% for five years until 2021, despite looking at the need for and feasibility of raising the rate [4,5].
The BOC reviews its benchmark interest rate eight times a year and considers local (e.g. federal election) and global (e.g. US-China trade relationship) influences, both current and potential, in their review. Although the central banks, including the BOC, operate independently of the government, they are ultimately responsible to Parliament through the Minister of Finance.
If inflation remains around 2%, the BOC may not see a need to change the rate. If inflation rises too quickly and needs to be slowed down, the BOC interest rate is raised to deter borrowing and spending and to encourage saving. If inflation is lower than 2% and there is a fear of recession, the interest rate is lowered to encourage people to borrow money and spend (rather than save) [6,7]. While the BOC does try to predict the future economic environment, it still takes six to eight fiscal quarters for its decisions to significantly affect the economy. They also have to take into account the US Federal Reserve’s interest rate decisions as the large size of the US economy and trade volume between US and Canada means that changes in the US will affect the Canadian economy as well.
Keep in mind that this is a very simplistic picture of what happens; it’s really much more complex than this.
The history of the BOC rate
The Bank Rate 1935-2018 chart  shows the changes in the benchmark interest rate for each month of the 80+ years covered. It’s interesting to compare today’s BOC rate of 1.75% to the bank rates of the past 80 years to see where similarities and differences lie as well as the state of the Canadian economy at those times. Here are some examples.
1939 -1945 – World War II
The bank rate started the WWII period at 2.5% in 1935 and ended at 1.5% in 1945. While the Canadian economy was under risk, the economy actually strengthened during the war as Canada played a vital role in supplying natural and manufactured resources to the Allies and subsequently also increased in the number of jobs available, especially for women. The decrease in the BOC rate encouraged people and businesses to borrow money to invest in new manufacturing plants and materials and in new housing [9,10].
1945 – 1955 – The post-war period
In the post-war period, the BOC rate didn’t rise to 2.0% (from 1.5%) until October 1955. This low-interest rate was to continue encouragement in the post-war period for investment in new infrastructure, manufacturing, housing and consumer goods [9,10].
1977 – 1991 – High inflation
After a period with a (generally) steadily rising BOC rate, the benchmark rate hit double digits for the first time in October 1978 at 10.25%. This was due in part to the global oil crisis and the OPEC oil embargo. With record-high prices for oil in August 1980 that continued into 1981, the BOC rate hit an all-time high of 20.03% in August 1981. The lowest rate reached during this period was 7.14% (March 1987). At this high interest rates, people put more money into savings rather than borrow money .
1991 – 2008 – Economic growth
After the recession of the 1980s, the BOC rate between 1991 – 2009 generally went downwards with only a few exceptions. The inflation-target rate was introduced at the beginning of this period.
2009 – 2017 – The Great Financial Crisis and record low-interest rates
After the recession of the 1980s, the BOC rate between 1991 – 2009 generally went downwards with only a few exceptions. The inflation-target rate was introduced at the beginning of this period. In March 2009, the BOC rate dipped below 1% for the first time to 0.5%. The timing of this drop coincided with the 2008 financial crisis in the United States and the collapse of the price of oil that prompted a similar recession in Canada . In 2014, oil prices dropped a staggering 60% due partly to production exceeding demand . Another recession hit Canada and lasted for six months. However, the BOC rate, which was at 1.25%, did not change until the beginning of 2015, at which time it dropped from 1.25% to 1.0% and continued to drop until 0.75%.
2019 -2020 – Now
The current (as of December 2019) BOC rate is 1.75% and the inflation rate is around the BOC’s target of 2% . With no pressure from inflation, one can predict that the BOC can afford to keep the benchmark rate steady.
However, today’s BOC rate is still low from a historical standpoint. For fifty years, from 1958 – 2008, the BOC rate never dropped below 2%; for almost 75 years (1935-2009), the rate never went below 1%. Today’s rate and those of the last 10 years, rivals the interest rates in place in Canada during World War II and the post-war recovery period [20,21].
The BOC rate and homeownership
We said earlier that the interest rates for all borrowing and lending transactions, including your mortgage, with financial institutions correlate with the BOC rate.
The BOC rate has a direct effect on variable mortgage rates as they are based on lender prime rates that tend to follow the BOC rate. However, fixed-rate mortgages are linked to government bond yields that are decided by market forces. However, the BOC rate has an indirect effect on fixed-rate mortgages as the BOC’s rate affects the Government of Canada five-year bond yield on which fixed-rate mortgages are based [14,15,16].
Home prices and affordability
So how does the BOC rate affect how much homes cost? Not surprisingly, many factors need to be taken into consideration (immigration levels; employment statistics etc.) but in general, low-interest rates could lead to rising house prices. Low costs of borrowing (e.g. mortgages) encourage people to buy their own homes. More buyers for a limited pool of homes means there is more competition and sellers sell their homes for higher prices. Some segments of the market with limited supply, such as starter homes, may have price increases so radical that home buyers are priced out of the market [7,13]. In addition, your location has an effect. Since 2008, home prices in Toronto and Vancouver have increased faster than the national average and homes there have been more expensive than the average home across Canada .
Looking at historical BOC data and property prices shows this relationship. The year-to-year increase in the average price of new-build homes in Canada was greatest around 1986-1991 at around 16%. The Canadian economy couldn’t sustain these high home prices with the increased interest rates and the growth in new home prices slowed down, with home prices falling year-on-year in 1992 [22,23].
Another way of checking whether house ownership is affordable is not to look at the home prices themselves but to consider what portion of your disposable income would have to go towards housing-related expenses. The higher the ratio, the more difficult it is to afford a home. The House Affordability Index (HAI) is such a measure . Remember though, that home prices and mortgage payments are just one element of the HAI; incomes, prices of consumer goods and the cost of utilities are among the other factors considered. But it does indicate whether homeownership was affordable given the Canadian economy at the time.
Mortgage stress test
There is one more twist in the story of the BOC rate and your new home – and that’s the mortgage stress test.
The CMHC mortgage stress test was introduced in 2018 to ensure that, if there were a recession and interest rates rise, people would still be able to afford their mortgage payments, preventing a slew of defaults that could crash the economy. Currently, anyone applying for a new mortgage or refinancing an existing mortgage with a different financial institution has to prove that they can manage mortgage payments at a higher interest rate than that of their current mortgage. This higher interest rate is the higher of their mortgage rate plus 2% or the BOC 5-year fixed-term rate [17,18].
The effect of the mortgage stress test is that, even with low-interest rates, the purchasing power of home buyers can be up to 20% less than before . This means that they may have to settle for a cheaper home or may even be forced out of the market.
The bottom line
Even though it’s quite complex, the route from the BOC benchmark rate to the price of your new home is worth following. Examining the historical record for the BOC rate and its relationship to home affordability shows that you should consider the BOC rate along with the economy, the inflation rate, mortgage rates, and the rate of increase or decrease in property prices before buying a home.
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