Prime rate graph pointing up

The Bank of Canada (BoC) will be meeting next Wednesday (March 2, 2022), and most economists and forecasters expect that it will raise the Prime lending rate by 0.25%. This will be the first rate increase we’ve seen since the BoC slashed rates at the start of the pandemic in early 2020.

Why is Prime Increasing?

The BoC is expected to raise Prime several times over the 2022 and possibly even more in 2023. It will do this because our economy is beginning to experience persistent inflation due to

  • ongoing supply chain bottlenecks (caused by the pandemic and more recently border protests) which are reducing the amount of goods coming into the country, combined with
  • excess money injected into our economy through the economic stimulus measures taken over 2020 and 2021 to help offset financial hardships and business closures as a result of the pandemic, which means people have more money to spend chasing those fewer goods available.

and inflation, if left unchecked and increasing, is very bad for everyone.

By increasing Prime, the BoC reduces the supply of money going into the economy, which over time should slowly reduce the amount of money available to be spent and thus slowly cause prices to stabilize.

Impact on Borrowers

Unfortunately, a side effect of the BoC raising Prime is that all the consumer banks and mortgage companies will also raise their customer Prime rates, which will increase the borrowing costs for anyone with Adjustable Rate mortgages, Variable Rate mortgages, and Lines of Credit.

Adjustable Rate Mortgage: your mortgage payment will increase when Prime increases, so you continue to pay the same amount to principal with each payment but you pay more in interest.
Common lenders: Scotiabank, Merix, RMG, First National

Variable Rate Mortgage: your mortgage payment does not increase when Prime increases, but with each payment more goes to interest and less goes to principal and your mortgage ultimately takes longer to pay off.
Common lenders: TD, RBC, CIBC, BMO, most credit unions

Line of Credit: typically the minimum payment required is just the interest accrued, and so your minimum payment will increase as Prime increases.

Does this mean an Adjustable Rate mortgage is bad?

However, just because Prime will be going up over the coming years does not necessarily mean having a Variable or Adjustable rate mortgage is bad. At the end of the day, it comes down to how much interest will be paid compared to the alternative options of a fixed rate mortgage. It also depends on your long-term plan for your property.

For comparison purposes, let’s look at a current 5 year fixed mortgage compared to a 5 year Adjustable Rate mortgage for a refinance (where you already own your property).

Today, a 5 year Fixed mortgage rate is going to be between 2.89-3.29% (depending on the lender, amortization, property type, etc). Splitting the range at 3.09% and assuming a 25 year amortization and a mortgage amount of $100,000, the mortgage would have $477.88 monthly payments and over 5 years cost a total of $14,294.41 in interest.

A 5 year Adjustable rate mortgage runs at Prime – 1.2% to Prime – 1% right now, for an effective rate of 1.25% to 1.45% today (prime is current 2.45% with most lenders). Using 1.35% for our example (Prime – 1.1%), here is now the mortgage payments would change over the next few years as the BoC increases Prime:

PrimeEffective RatePayment
2.45% (Today)1.35%$392.93

As you can see, it takes 7 increases of Prime by 0.25% (the typical prime rate change by the BoC) before the Adjustable Rate mortgage option matches the 5 year fixed option for interest and Monthly payment.

If those rate increases come to pass slowly over the next 2-3 years, the people with Adjustable rate mortgages will be saving a substantial amount of money through the lower interest costs, and benefitting from lower monthly payments. And if something happens in 2023 or 2024 that causes the BoC to stop raising Prime, or even have to cut it again, the Adjustable rate client will possibly never end up paying as much interest or have as high a payment as the client that takes a fixed rate mortgage today.

The other significant benefit of having an Adjustable rate mortgage is that if you cancel the mortgage before the term is up, the penalty is only ever 3 months interest. In our example above for a $100,000 mortgage, that penalty would be somewhere between $500 and $750 depending on exactly what the interest rate is when the cancellation occurs. A fixed rate mortgage can be subject to a much larger cancellation penalty called an Interest Rate Differential, which can be several times larger.

What is the downside of an Adjustable Rate mortgage?

The most substantial risk of having an Adjustable rate mortgage is in regards to budgeting and cash flow – your payments might continue to go up over 2025 and 2026, ending up substantially higher than $477.88 per month (the payments of the 5 year fixed rate option).

If you have a fixed income (pension, annuity, etc) and cannot comfortably adapt to mortgage payments higher than a specific threshold, then the security of a fixed rate mortgage might be best even though it means paying more in interest and having higher payments over the next few years. It’s like buying insurance – you pay more money in interest today for the peace-of-mind of having set payments for 5 years.

Considerations for Variable Rate mortgage clients

If you have a Variable Rate mortgage, your payments do not automatically increase when Prime goes up. Instead, more of your payment goes to paying interest costs, leaving less to go to principal. If you want to keep paying the same amount towards your mortgage balance with each payment, you can contact your lender after a Prime rate increase and request that they increase your scheduled payments to keep your overall amortization (the amount of time it will take to pay your mortgage off) constant.

Lenders that follow a Variable Rate policy include TD, CIBC, RBC, BMO, and most credit unions.

My mortgage amount is more than $100,000

You can roughly calculate your own hypothetical payments from the above illustration by multiplying them by your mortgage factor. To calculate your mortgage factory, just take your mortgage amount and divide by $100,000.

For example, if your mortgage is $250,000, your mortgage factor is 2.5 and the monthly payments for a variable rate mortgage today would be $392.93 x 2.5 = $982.32.