What You Need to Know About the Bank of Canada’s Overnight Rate

We explain the relationship between the central bank’s overnight rate and inflation — and what it all means for homebuyers and mortgage borrowers.

By Josh Sherman | 5 minute read

The overnight rate is the Bank of Canada’s number-one mechanism for guiding inflation in the economy.

Anyone who follows Canadian real estate — or isn’t completely disconnected from the news — has probably at least heard of the Bank of Canada’s overnight rate.

Also known as the key interest rate, the overnight rate is set by Canada’s central bank, a Crown corporation that acts with “considerable independence” from the federal government, eight times per year. These policy announcements create lots of fodder for headlines and commentary from experts, casual observers, and anyone in between. House hunters and owners typically cheer rate cuts and curse hikes, but what is the overnight rate, really?

In this blog post, Wahi helps homebuyers get so in the know by defining the overnight rate (without any jargon), explaining what it does (without any jargon), and laying out what changes to it mean for consumers (you guessed it — without any jargon).

The Overnight Rate: The Basics Explained 

For a no-nonsense definition of the overnight rate, Wahi turned to Moshe Lander, a senior economics lecturer at Concordia University, in Montreal. He told us what he says he tells his first-year students: “It’s the rate at which banks can borrow and lend with other banks… at extremely short durations — in parentheses, overnight,” he says. “All interest rates are tied to that [overnight rate],” he adds.

The overnight rate is also the central bank’s main tool for controlling inflation. Since the 1990s, the Bank of Canada has aimed to keep inflation within a band of 1 to 3%. Lander likens this level of inflation to applying the right amount of grease to a wheel to keep it spinning. “If you have no grease on the wheel, that wheel is going to crack, it’s going to break, and you’re not going to be able to move. You put too much grease on the wheel, and it’ll spin and gain no traction, and you won’t be able to move,” he tells Wahi. “Just a little bit is enough, and it gives you a little bit of traction without the risk of it breaking — that’s the inflation story,” he adds.

How Does the Overnight Rate Impact Inflation?

When demand for goods and services increase, prices increase — that’s inflation. One way to reduce demand and curtail inflation is to increase the cost of borrowing money via a rate hike. “Doing so encourages financial institutions to increase interest rates on their loans and mortgages, discouraging borrowing and spending and thereby easing the upward pressure on prices,” according to the Bank of Canada. (Conversely, in a recession the central bank can cut the overnight rate to try and spur economic activity.)

However, experts note — and the central bank itself states — that it takes time for rate changes to impact the broader economy, generally about 18 to 24 months to feel the full effects. “There’s a common belief that the moment that the Bank of Canada adjusts the overnight rate, the inflation rate adjusts the following morning,” says Lander, citing what he says is the biggest misconception Canadians have about the overnight rate.

Why the lag? There are four components to a macroeconomy, says Lander — households, businesses, governments, and foreigners. “When you adjust interest rates, it affects all of them, but in different ways,” he explains.  “Businesses move quickly,” he notes, adding that investment behaviour is particularly sensitive to rate changes. The same isn’t true for everyone. “Consumers are much slower to change their behaviour because we try to do everything we can to maintain a certain standard of living, a certain lifestyle,” he says. “So, when interest rates go up, we’ll try and cut back on little things before we make a serious change to our lifestyle decisions.”

What Do Changes to the Overnight Rate for Homebuyers and Owners? 

A change to the overnight rate will affect different homebuyers and owners differently. “If you have a fixed-rate mortgage… the only time it would affect you is when you’re next up for renewal,” explains Lander. Banks calculate fixed rates based on where they expect interest rates to be by the end of the mortgage term (how long the loan contract is in effect), most commonly five years in Canada.

Variable-rate mortgages, on the other hand, are more in sync with the overnight rate. Variable-rate mortgage shoppers may almost immediately see higher advertised rates. But it doesn’t mean an existing variable-rate borrower will see their payments immediately increase after a rate hike. “Your monthly payment generally doesn’t change — it’s the amount of that payment that goes to principal and interest that changes,” he adds.

Typically, over the term of a mortgage, more and more of a borrower’s payments go towards the principal (the amount borrowed). “The only time [the bank] would actually change the payment is if the payment is now no longer sufficient to cover the interest,” he says, which can occur after repeated or large increases to the overnight rate. In this scenario, variable-rate borrowers will face their bank’s trigger rate — the rate at which borrower’s are no longer contributing to the principal — bringing on higher monthly payments.