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Orginally posted by desi in ottawa

Can someone please clarify the meaning of prime rate? I spoke to the bank yesterday and I was told that the prime rate is 4.25%. What is a prime rate? How different is this with the interest rate on the morgage? I have a mortgage at 4.35% locked for one more year. Am I paying more now? Should I start talking to other banks?

DIO

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Prime rate is the rate on which Bank's lend money to their 'prime customers'. The current prime rate is 4.25%. This rate is linked with Bank of Canada's overnight lending rate, which at present is 2.50%. In its meeting yesterday, the Bank of Canada did not change this rate and hence the prime rate did not move. Bank of Canada moves this rate up or down depending on various macro and micro economic factors to control the inflation etc. and makes this decision 8 times a year. This overnight lending rate is the rate Bank of Canada wants all major banks to lend money to each other or they can borrow money from Bank of Canada at this rate. Then the major banks add their margin (which at present is 1.75%) and lend money to their customers.

http://www.bankofcanada.ca/en/fixed-dates/2005/rate_120705.html

The variable rate is linked with this prime rate while the fixed rates are linked with the rates in Bond Market and any ups and downs their affect the fixed rates quoted by the major banks for their deposit and lending products.

Here is an old article from National post which might make things more clear.


From the National Post Business Magazine - May 2003
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Although economists like to talk about interest rates going up or down, the fact is that the interest rate is not a single number. Rather, there is a whole range of rates reflecting different term periods; if you borrow money for a month, you will pay one rate, while if you borrow for five years you will pay another. And these numbers can move in entirely different directions.

Short-term interest rates are driven by the Bank of Canada overnight rate, the minimum rate at which the bank lends money to financial institutions. Raising that rate allows the Bank of Canada to fight inflation by making it more expensive to borrow money. A variable-rate mortgage is directly linked to this rate, and as the bank raises or lowers its overnight rate, your monthly mortgage payments will move up or down as well.

Fixed mortgage rates work differently. Rather than being tied to the bank rate, mortgage lenders link their fixed mortgage rates to the market using bonds. As bond yields rise or fall, so do long-term mortgage rates.

The two numbers can move in opposite directions because they reflect different market expectations. When the bank raises its rates, it's doing so to fight today's inflation and reduce the expectation of future inflation. However, if investors think inflation is going to fall, this may have the effect of lowering long-term bond yields. Here's a simple
description of how that might happen:

Bonds pay out a set return (the coupon rate) which is a percentage of their original price. If inflation goes down, bonds' "real return" (the return after inflation is subtracted) improves, so investors would be willing to pay more for them. In turn, when bond prices go up, the return on bonds (the "yield" goes down. Since long-term mortgage rates are tied to bond yields, lower yields translate into lower fixed rates. So if markets think inflation is falling, fixed mortgage rates might also fall, despite the fact that variable rates are rising.

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Now to your question. Whether the rate of 4.35% for the remaining 1 year is good or not. I would say it is not a bad rate, however, right now you can get a 5 year rate at 4.35% and you do not know when your renewal comes after 1 year what rates you would be getting. The variable rate is at around 3.45% (prime - 0.80%) and would remain same through out the 5 year term (prime -0.80) and would move up or down with the movement in prime rate which in turn moves with the change in Bank of Canada's overnight lending rate.

You can convert your mortgage in to a variable rate mortgage but you might have to pay a penalty and depending on that penalty amount we can do a calculation whether it would be beneficial for you to change your mortgage now or not. You can send me an email at pchopra@tmacc.com with the details such as the cost of the house, mortgage remaining, original price and original down payment, date of purchase and the original term taken and I can let you know the best course of actions for you.