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What is the Overnight Rate?

25 January, 2012 / by Bryan Jaskolka

Canadians watch the Bank of Canada’s interest rate like hawks, wondering what’s going to happen to the overnight rate and the prime rate. But aren’t these two the same thing? That is where it can get a little confusing. Historically the prime rate was the same as the overnight rate, so if you were referring to one you were also referring to the other. However, this is no longer the case and there is a real difference between the two.

The overnight rate is the rate that the Bank of Canada is responsible for monitoring and changing. This overnight bank does have an effect on the prime rate, but the two are not the same thing. The overnight rate is the rate at which banks lend money to each other every day. At the end of each day, banks must balance out their books and if they don’t have enough funds, they will borrow from other banks. If a bank has a surplus of cash at the end of the day, they’ll loan it out to other major Canadian banks for a short-term period. Just like any other loan, these bank loans have interest attached to them, and that interest is determined by the overnight rate – the rate that the Bank of Canada is responsible for.

The overnight rate determines quite a bit in Canada. It determines the value of the Canadian dollar in foreign markets, and it also determines the variable rate for ARM mortgages and for secured lines of credit. While it’s mostly variable rate loans that are most affected by the overnight rate, fixed rate loans such as home equity loans are still affected by the interest rate, as they’ll still have interest tied to them, even if it’s a fixed amount. The interest rate on credit cards and student loans is also largely determined by the overnight rate.

The overnight rate in Canada is reviewed 8 times a year, and it’s at these times that the Bank determines whether or not the rate needs to be changed. Currently the rate sits at 1%, the same rate it’s been since September of 2010. The overnight rate differs from the prime rate in the way that the overnight rate is the rate the Bank of Canada determines and the major banks are expected to follow it as a guideline. The prime rate on the other hand, is the rate the individual banks will charge their customers. So even though the overnight rate currently sits at 1%, BMO’s prime rate (which is currently sitting at a discounted rate,) is 3%, because the individual banks set the prime. The prime rate however, is still closely monitored by the Bank of Canada and the prime will change any time there is a change in the overnight rate.