How Do Lower Interest Rates Affect Your Life?

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The Bank of Canada cut its key interest rate to 2.25% on October 29, continuing the rate-cutting cycle that began in June 2024. Today, we want to go back to basics and explain how interest rates actually work, and what to pay attention to in every Bank of Canada announcement. Here's what lower interest rates mean for you, for small businesses, and for the Canadian economy.

What Are Interest Rates?

Interest is the fee consumers or institutions pay to borrow money. It's also what a bank may pay a customer for holding money in their account. When you take out a loan, "you get cash, and you'll need to pay back a portion of that loan over time," says Andrew DiCapua, chief economist at the Canadian Chamber of Commerce in Ottawa. "Part of that repayment includes interest."

Commercial banks such as RBC, Scotiabank, TD Bank, CIBC, and BMO use a "prime rate," their starting point for calculating what to charge borrowers. This rate is typically combined with an additional percentage calculated based on a person's creditworthiness.

The prime rate tracks the Bank of Canada's overnight rate, a tool central banks use to keep inflation in check. As a rule, the prime rate sits roughly 2%+ above the Bank of Canada's rate. Today, the prime rate at most commercial banks stands at 4.45%.

When inflation runs too high, the Bank of Canada may raise its key rate to discourage borrowing and excessive spending. DiCapua explains that this might, for example, push someone shopping for a new car to "choose a smaller or cheaper car," or put off buying a car altogether. But when rates fall, borrowing money becomes cheaper. And that often encourages people to spend more, which can help drive economic growth.

Lower interest rates can mean different things for different sectors of the economy. Because of this, the central bank has to balance potential growth against the risk of inflation whenever it sets its key rate.

How Interest Rates Affect the Real Estate Market

Property owners, particularly those with a variable-rate mortgage, are among the first to feel relief the moment the Bank of Canada cuts its rate. Their monthly mortgage payments will move up and down along with the rate.

For holders of variable-rate mortgages and home equity lines of credit (HELOCs), the October rate decision will have a direct effect. Their rate drops by a quarter of a percentage point. And for every $100,000 borrowed, a 0.25% cut works out to roughly $12 less per month on a variable-rate mortgage, and $20 less per month on a HELOC payment. Prospective homebuyers may also get an added push to enter the market once banks start offering lower variable rates, DiCapua notes.

Those with a fixed-rate mortgage won't see an immediate difference in their monthly payments. But anyone considering a purchase and comparing fixed-rate offers may also notice that rates have come down slightly (plenty of 3- and 5-year offers are already sitting below 4%). Fixed rates are influenced by bond yields, which have been declining over the past several months. This is why lower interest rates can lead to more home sales, which in turn can affect the broader economy. When rates come down, we also often see a psychological shift among buyers. Even a modest reduction in the burden from lower interest rates frequently sparks activity in the housing market, especially once people start thinking, "If I don't buy now, I'll miss my chance."

How Interest Rates Affect Small Business

Without the burden of high housing-related payments, consumers can direct more of their budget toward goods and services, putting their money into other sectors of the economy. Consumers like this "may, for example, have more disposable income to buy more goods at retail stores, or to spend more on tourism and entertainment experiences," says Simon Gaudreault, chief economist and vice president of research at the Canadian Federation of Independent Business.

On top of that, small businesses themselves may carry a variable-rate mortgage or other loans, such as a manufacturing company that took out a loan to purchase expensive equipment.

If the rate comes down, "that's good news for those business owners," Gaudreault notes.

But even as the central bank continues cutting rates, lower interest rates don't automatically translate into rosy prospects for business. The Bank of Canada recently surveyed companies on how they view the state of the economy, and the results were fairly subdued, particularly in the context of the trade war that has turned uncertainty into the new normal. As Gaudreault notes, businesses are dealing with labour shortages and rising operating costs (such as insurance premiums), and the cost of raw materials and components has climbed due to inflation and tariffs. "Right now, there's so much uncertainty, so much softness in the economy, that companies have to be very, very careful about where they put their money," Gaudreault says. There isn't much left over for new investment or hiring. They're holding onto cash to cover all of these increased operating costs instead.

How Interest Rates Affect Personal Finances

When it comes to personal borrowing, as with the car loan example, the cost of borrowing will fall right along with the prime rate.

The cost of borrowing on some credit cards, and especially on lines of credit, can also come down thanks to cheaper debt payments. For instance, if the cost of borrowing on a line of credit is high, a new homeowner might put off a renovation. If rates fall, they might use that credit to finance the renovation instead.

That said, lower interest rates can be less appealing for Canadians trying to save and grow their money, since financial institutions will pay depositors less for holding their funds.

Lower interest payments on savings accounts and Guaranteed Investment Certificates (GICs) can leave savers feeling a certain amount of "frustration."

What Else Should I Know About Rate Cuts?

"The relationship between interest rates and prices depends on how quickly or slowly the economy is growing relative to its capacity to produce goods and services," notes Andrew DiCapua of the Canadian Chamber of Commerce. When demand outpaces supply, and the economy needs more workers, capacity, or equipment than is available, that can push prices higher, he explains. But any change in interest rates takes time to work its way through every level of