What is the Overnight Rate?

Overnight Rate Definition

The overnight rate is the interest rate at which large banks borrow money, short term, among themselves.

The overnight rate can also be called the key interest rate. Canada’s major banks belong to the Large Value Transfer System (LVTS). It is an electronic system for these banks to conduct large transactions with each other. The accounts must be settled each day and to facilitate this, the banks might need to borrow funds from one another. The overnight rate is the interest rate at which Canada’s commercial banks borrow and lend funds on a one-day basis to each other. Thus, the rate has been called the overnight rate.

How the Overnight Rate is Changed

The Bank of Canada will provide 8 dates per year to set a “target overnight rate.” It may change the target rate to help control inflation, or to affect lack of credit confidence. In some cases, the Bank of Canada may leave the target overnight rate unchanged.

The Bank of Canada may use the overnight rate to influence Canada’s monetary policy, if the target rates set by the Bank of Canada are not being met. It does not set the rate directly, but may influence it buy adding or withholding its reserves to the available surplus of money to lend.

Effect of the Overnight Rate on Mortgage Rates

Changes in the overnight rate have an indirect effect on mortgage rates and a rise in the overnight rate will usually show a rise in the mortgage rates. If the overnight rate is increased, and the larger banks will pay more in interest to settle their accounts, they will need to increase their own interest rates, both through the prime lending rate and through business and consumer rates.

The interest rate of variable rate mortgages is tied directly to the prime lending rate, which is in turn influenced by the overnight rate. If there is an increase in the prime lending rate, the rate of variable rate mortgages will also increase. Because a bank’s profit margin will narrow if it leaves its prime rate unchanged in the face of an increased overnight rate, it will almost always increase the prime rate.

At First Foundation Residential Mortgages, we monitor the overnight lending rate, as well as the prime lending rates to look for trends and determine when the best time to secure a mortgage will be.

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Last updated Apr 10, 2014