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What is the prime rate on a loan?
Learn how this annual interest rate affects the variable interest on loans on mortgages.
You might have come across the Bank of Canada prime rate when trying to figure out how much a loan costs. The prime rate rises and falls based on the lending market, so there’s the potential that you could pay much less — or much more — in interest compared to a loan with a fixed interest rate.
What is the prime rate?
The prime rate, also known as the prime lending rate, is the interest rate that the big 5 Canadian banks give to their most creditworthy borrowers and it fluctuates based on the state of the lending market and overall economy. It’s based on the Bank of Canada policy interest rate. If you have strong credit and overall personal financials, you could qualify for a loan based on the prime rate alone. Otherwise, lenders typically treat the prime rate as what’s known as a benchmark or starting rate on a variable-rate loan.
The prime rate affects the interest rate of:
- Variable-rate personal loans
- Variable-rate mortgages
- Variable-rate car loans
- Variable-rate student lines of credit
- Home equity lines of credit
- Some credit cards with variable-rate APRs
How does the prime rate work?
Lenders give borrowers a smaller fixed percentage called a margin rate, and then add that number to the ever-changing prime rate. You might hear it as, “prime plus 2”. This means your interest rate is whatever the prime rate is plus 2%. So, if you got a variable-rate loan at 2% margin rate + prime — and the prime rate was 3% — you’d actually pay a 5% interest rate. If the prime rate goes up to 6%, then you’d pay an 8% interest rate.
How is the prime rate calculated?
The Bank of Canada calculates it’s policy interest rate (also known as its target for the overnight rate) based on the state of economy. Its mandate is to “promote the economic and financial welfare of Canada” so it may adjust the rate to either reign in consumer spending and curb inflation or to respond to a weakening economy from the affects of a pandemic like coronavirus. Once the Bank of Canada sets its rate, the major banks usually respond by setting their prime rate the same within a few days.
You can typically get an idea of the prime rate by looking at the interest rate banks charge each other on overnight loans if they don’t have enough cash in their reserve when the day is over.
What loans use the prime rate?
Any variable-rate personal or business loan might use the prime rate as a benchmark. It’s also common with mortgages and other types of home loans. However, not all variable rates are based on the prime rate.
Private student loans
You might run into the prime rate if you’re looking for a student line of credit from one of the major banks or from a private lender or if you want to refinance your student debt. That’s because most student loan providers offer a choice between fixed and variable rates.
Business loans
Fixed-term business loans and lines of credit often come with variable rates — many of which are based on the prime rate. Unlike with student loans, you typically don’t have a choice between fixed or variable rates. The lender usually offers one or the other. Still, many types of alternative business financing — like invoice factoring — rely on other fee structures that don’t involve interest at all.
Personal loans
Prime rate isn’t as common on general-use personal loans — many lenders only charge fixed rates. You’re more likely to find a variable-rate personal loan based on the prime rate if you apply for a loan with a big bank — and even then it’s more common with unsecured lines of credit.
Car loans
Variable rates are even less common with car loans than personal loans, meaning that you probably won’t have to worry about the prime rate when getting your next set of wheels or refinancing. Like with personal loans, variable-rate car loans that rely on the prime rate are more common with big banks than smaller online lenders.
Home loans
Variable rates are perhaps the most common with home loans. Adjustable-rate mortgages come with a period of fixed interest rates and another with variable rates that might be based on the prime rate. But it’s more common with home equity loans and lines of credit.
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Bottom line
Understanding the prime rate can give you a better idea of how much a variable-rate loan will cost. Since it changes based on the state of the economy, you could end up either saving or paying a lot more than you would with a fixed-rate loan.
To learn more about how loans work, read our guide to personal loans.
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