Earlier this month, the Bank of Canada made its sixth (out of eight for the year) interest rate announcement and for the third time this year, they lowered the overnight rate.
For most people, the reason why mortgage rates change is a complete mystery. While the idea that a person with a good job and good credit can get a good mortgage rate is clear, the changes in mortgage rates can seem arbitrary.
Will mortgage rates rise or fall this year? Should I lock in now or wait until later? Is fixed a good idea or should I go with variable?
It is a confusing situation on the surface but the good news is that there are actually only two factors that influence mortgage rates. Let’s look at what they are and how they impact the two types of mortgages and see which makes sense for you.
Let’s call it the cost of risk.
There are just two factors that impact mortgage rates, but they are a little bit complicated.
The factors are:
- The cost of funds (today as well as later); and
- The lending environment.
At its most basic, lenders are in business to make a profit. If there was no competition, lenders could charge what they want for mortgages. Fortunately for anyone looking to get a mortgage, a competitive marketplace keeps rates low in good times and reasonable in bad times.
Let’s take a look at the two main types of mortgages – fixed and variable – and how the cost of funds and lending environment impacts rates.
Fixed Rate Mortgages
This type of mortgage, with a single interest rate set for the term of the mortgage, is the most popular in Canada. The CMHC Mortgage Consumer Survey 2024 shows that 69% of consumers in Canada in 2023 chose fixed rate mortgages.
In order to make a profit, lenders need to charge enough so that they make more from you than their cost for borrowing that money. While we may perceive lenders as simply having the money and loaning it to us, lenders are themselves typically borrowing the funds. In today’s market, that is normally from selling what are known as mortgage backed securities.
Purchasers of such mortgage backed securities would traditionally buy long term government or investment grade corporate bonds, so the rate to be charged on fixed rate mortgages is dictated by rates that are paid on such bonds. If bond rates rise, fixed mortgage rates rise as mortgage backed securities need to remain competitive with these bonds.
There is an entire industry following the bond market that focuses on predicting changes in the bond rate and it is from these predictions that 1, 2, 3, 4, 5, 7 and 10 year bond rates are set, which in turn dictate the basic mortgage rates for those terms.
A lender who deals in fixed mortgage rates therefore knows their cost of funds today and the anticipated costs of funds later. They take that cost of funds and charge a premium (also called a yield or spread) on top to come up with their fixed mortgage rates. This premium is where we see the lending environment impacting the mortgage rates that are offered.
For fixed mortgages, the lending environment that is relevant is the activity in the bond market, particularly the investment grade corporate bonds. Broad economic and environmental factors influence our perception of risk and the return we need in order to justify that risk.
In simple language, if an investor is deciding between investment grade corporate bonds and mortgage backed securities, they look at which has the most risk. While in general both are supposed to be equal in risk, the reality is that there are fluctuations in perceived risk. If investment grade corporate bonds are perceived as safer than mortgage backed securities, lenders need to offer a bit higher a rate in order to get investors to buy. When that happens, lenders raise the mortgage rates they offer consumers.
If the reverse is true and investment grade corporate bonds are perceived as riskier than mortgage backed securities, then lenders can offer a comparable rate and have investors buy in. In such cases, lenders keep the mortgage rates the same or perhaps even lower the rates a little.
It is this combination of perceived risk in the lending environment and the cost of funds (both now as well as the anticipated cost later) that influence fixed mortgage rates. Let’s turn now to variable rate mortgages, which have different influences within the same factors.
Variable Rate Mortgages
This type of mortgage, with an interest rate that changes over the term of the mortgage, is the other popular mortgage type in Canada. The CMHC Mortgage Consumer Survey 2024 shows that just 23% of consumers in Canada in 2023 chose variable rate mortgages. (The remaining 8% are more complicated, mixed versions.)
As the name “variable rate mortgage” implies, the rate you are paying changes over time. In this type of mortgage, the lender does not need to worry about the anticipated cost of funds later as if their costs go up, so does your rate. How then, do you as a consumer, understand what causes the variable rate to change?
All variable rate mortgages use what is called the bank prime rate as a starting point. This is a rate that is mostly constant across all lenders and is itself based on the Bank of Canada overnight rate. The overnight rate is the interest rate at which major financial institutions borrow and lend one-day (or “overnight”) funds among themselves.
Financial institutions set their own bank prime rates based on this overnight rate and on competitive pressures among themselves. As the overnight rate strongly influences bank prime and therefore the variable mortgage rates, paying attention to announcements from the Bank of Canada is quite useful for understanding rate changes.
The Bank of Canada has eight (8) scheduled key interest rate announcements per year and apart from the announcement of what the rate now is, each announcement is scrutinized to try to determine what will happen in the future. We have just two more announcements to take place this year.
For variable rate mortgages, we now see that the risk attached to cost of funds at a later date is effectively removed. By signing you up for a variable rate, lenders assure themselves that whatever the changes, they can pass those changes on to you. As such, the other factor influencing the rates – the lending environment – is what remains.
As discussed, lenders use their bank prime rate and offer variable rate mortgages based on it. Competition amongst lenders, however, dictates whether lenders offer below prime, at prime or above prime rates. While collusion is not permitted, in such a tightly interwoven marketplace, competition forces lenders to adjust very quickly to rate changes by other lenders.
This means that while Bank of Canada rate changes will certainly change the variable rate of your mortgage, competition between lenders will also affect what rates are offered for variable rate mortgages.
For consumers, variable rates need more consideration as any changes in the prime rate are passed right on to them. Choosing a variable rate that is lower than a fixed rate mortgage could seem smart, only to see the prime rate (and hence the variable rate on your mortgage) rise over time above what you could have been paying with your fixed rate mortgage.
While setting mortgage rates is by no means a simple process, understanding that the cost of funds (today and later) and the lending environment are the influences that effect what you as a consumer pay for your mortgage is a very useful concept.
So, which one is best?
Deciding which type of mortgage is best for you is very much dependent on your situation and your own comfort level with risk.
Your personal situation influences the rates you are offered and that can be due to many different aspects.
- If you have a particular professional background (such as being an engineer), you may be offered a discount on the rate being offered to the general public due to a lower perceived risk in the eyes of a lender.
- If you have a prior bankruptcy or debt consolidation on your credit record, you may only be able to get a mortgage from a “B” lender, who doesn’t offer variable rate mortgages, only fixed rates.
- If you have a significant down payment, you may find that the best rate comes with a variable rate mortgage. Conversely, if you are putting down less than 20% of the purchase price as a downpayment, you may find that fixed rates are better than variable rates.
Make no mistake, the rate you are offered differs tremendously based on your personal situation and which lender is most interested in the risk profile you fit within their lending criteria. We recommend our clients use a mortgage broker to help find the lender that considers you a good risk so that you can get the best rate.
In addition to your personal situation, your own comfort with risk can determine which is the “best” type of mortgage for you to chose. If you are uneasy with the idea of the interest rate fluctuating over time and potentially reducing the amount of principal you are paying down with your payments, then a fixed rate may be the way to go. If you’re good with a potential upside (as well as downside) from changing interest rates, than a variable rate might make more sense. Again, a qualified mortgage broker can help you work through the options, the differences and help you decide which makes the most sense for you.
While we don’t work as mortgage brokers or lenders, we do believe that your real estate agent should understand how mortgages work and the current lending environment. It directly influences real estate markets and regardless of whether you’re buying or selling, you need an agent that isn’t blindsided by the impact of interest rates. Get in touch with us if you’re thinking about making a move!
