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:

1. The cost of funds (today as well as later); and
2. 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!

On Wednesday, September 4th, the Bank of Canada made its sixth (out of eight for the year) interest rate announcements and for the third time this year, they lowered the overnight rate by 25 basis points. Banks lowered their prime rate as a result, and it now sits at 6.45%.

As a quick reminder, the prime interest rate is the reference rate used by financial institutions to determine the variable interest rate they will offer for loans to businesses and individuals. It is the initial cost of borrowing money and while it can go higher (if the lender thinks you’re a risky loan) or lower (if the lender thinks you’re a safer loan), prime is where it all starts.

In the real estate world, the prime rate is critical as any homeowners who have a variable rate mortgage are directly impacted by a change in prime rate. Such mortgages are typically structured around an interest rate base on prime plus (or minus) a certain number. As a result, when prime goes up or down, the effective interest rate that variable rate mortgage holders pay goes up or down.

The 25 basis points (or a quarter percentage in layman’s terms) drop on September 4th was the third in a row and means that variable rate mortgages are now at a three quarters of a percent lower interest rate than earlier in the year. Given the high cost of real estate in Toronto and the GTA – and correspondingly high mortgage amounts – that is a welcome change for homeowners with this type of mortgage.

That being said, we’ve previously written about the relatively minor impact of a 25 basis point drop, which basically makes every $100,000 of mortgage about $14 cheaper per month to finance.

While that isn’t a lot of difference, we’ve now had three of these twenty-five basis points drop to prime, so it is starting to add up. Speaking of adding up, we thought perhaps it was time to do some simple math on what a variable rate mortgage costs at this new interest rate.

We were curious how much of an impact these drops have had on affordability and decide to look back to the last time interest rates were at (or very close) to this level. Our idea was to compare the cost for a typical 80% ratio mortgage, using the average price in Toronto and the other parts of the GTA, to see how much it would have cost on a monthly basis to own a home at the current variable interest rate.

Let’s get to it!

It feels just like Christmas.

Back on December 8, 2022, the Bank of Canada raised the overnight rate again and as a result, prime increased to 6.45%. The overnight rate went up three more times after that, and topped off at 7.2% (which made prime 5%) in July, 2023. After almost a year, the overnight rate started lowering, dropping once on June 5, 2024, a second time on July 24, 2024 and a third time on September 4, 2024. As the overnight rate dropped, so did prime.

We’re now back at the prime rate we had at Christmas in 2022, but the market has not seen significant change in average prices in Toronto or any of the GTA since that time. On paper that means that our housing market is more affordable now than it was almost two years ago, at least for people financing their homes with a variable rate mortgage.

We say more affordable, but that doesn’t equal affordable. We’re going to have to go back a lot further to do an apples to apples comparison for prime rate to see how unaffordable real estate really remains here in the GTA.

Wait, Apple makes phones now?

It was in 2007 that Steve Jobs introduced the first iPhone and while they are still around, they are quite different than the first one. That’s not the only thing that has changed since 2007, as we have seen incredible increases in average house prices in Toronto and the GTA since that time.

Despite the many chances since then, November, 2007 was the last time we had a prime rate as close to our current one. It was 6.25% rather than our 6.45%, but after November, 2007, it started decreasing and over the next number of years, it remained below our current level. This didn’t change until we hit it again in December, 2022 and then surpassed it, before coming back down again.

If variable mortgage rates were the same back in November, 2007, how did the lower real estate prices translate to mortgage payments and affordability? The answer is astonishing, so brace yourself.

Oh, right, first, the methodology.

We wanted a broad review that gave us some specific results, so we looked up some key datasets.

First off, we looked at the average price for a detached house now (August, 2024) and back in November, 2007. We did that for Dufferin, Durham, Halton, Peel, Simcoe, Toronto and York, so we’re not going to just give Toronto focused, or GTA averages. Oh, just for fun, we also did it for December, 2022, when we last briefly saw this same current prime rate.

Secondly, we took those average prices for those three times, assumed a 20% deposit and calculated the monthly payments for an 80% down mortgage with a 25 year amortization, using the prime rate of 6.45%.

Finally, we applied the standard 32% maximum total debt service ratio to calculate what you would need to have as a gross annual income to afford a detached home in each of those areas, both back in 2007, as well as in 2022 and now.

Let’s see what we found.

Welcome to Dufferin, hope you make 3X more than you used to make.

We’ll start with Dufferin, currently the most affordable place in the GTA to buy a detached house, with an average price of $949,000. That works out to over $5K a month in mortgage payments and in order to qualify, you’d need to make about $190K a year. Clearly, the “most affordable” doesn’t translate to “affordable” by most standards.

When we look back in November, 2007, you had to make about $59K a year to afford your mortgage payment of $1,560 a month on your $292,000 detached house. The interest rate may be the same, but the cost of the home means the income required has more than tripled since 2007.

This is unfortunately not the only area where incomes have had to rise drastically to be able to afford a detached home. In fact, in six of the seven areas we reviewed, incomes would have had to more than triple since 2007 to keep the same level of affordability for the current average detached house price. It will come as no surprise to you that this has not happened.

When did Durham start having million dollar houses?

Moving on to Durham, the latest average price for a detached home is just over $1M, meaning you’d need a family income of over $200K in order to qualify for your monthly mortgage payment of about $5,400.

When we look back to 2007, the average price was $310K and a family making about $62,000 could afford a home in the area.

Halton homes cost half a million. Oops, sorry, I mean one and half million.

Back in 2007, the average price for a detached house in Halton region was under $500K, meaning you could qualify for the mortgage and make less than six figures.

With a monthly mortgage of over $8,300 now for the average detached home, you better have a good job that pulls in over $300K gross. That’s assuming you have the 20% down for the $1.559M average detached house price!

Peel is middle of the pack, but you still better have money.

The results for Peel put it in the middle of the seven areas that comprise the GTA. It’s cheaper than Halton, York and Toronto, but more expensive than Dufferin, Durham and Simcoe. As of right now, you need an income of $266,000 to afford the $7,100 a month mortgage payment on a detached home.

Back in 2007, Peel was still very much a bedroom community for commuters and you could buy your own detached home for just over $400K, on an income of $84,000. Ah, the good old days.

Simcoe is no Dufferin, but it’s close.

When we turn to Simcoe region, it’s one of only two parts of the GTA where the average price remains below $1M. It’s a little bit more expensive than Dufferin, but not by much. Our current variable rate still means you’d need to have over $5K a month for mortgage payments, and you’d need to have a gross family income of almost $200,000.

Way back in 2007, a family income of $61,000 was enough to get you into the detached housing market, where about $300K would get you your own house, driveway and backyard.

Wait, Toronto actually got a bit more affordable? Well, kind of.

Toronto was the only part of the GTA where we saw less than a tripling of the income required to buy a detached house. Before we start celebrating in the six, we’ll point out that the current average price for a detached home is the highest in all of the GTA, at almost $1.7M. That means your mortgage is over $9K a month and your gross income has to be around $339,000 to qualify.

The reason why Toronto didn’t have as big a jump in unaffordability is because it was already pretty unaffordable back in 2007. The average price of $614,000 was more than double a few other areas of the GTA, as was the income required to buy in the city. Toronto went up by 2.8x when we look at August, 2024 but given everywhere else was around 3.2x, it seems like it works out well if you start off being expensive.

York comes in a very close second.

Finally, when we turn to York region, we have an average price of $1.665M, just a bit below Toronto. The monthly mortgage payment for the average detached home would be just under $9K, and you need a cool third of a million in annual gross income in order to qualify for the purchase.

York was pretty expensive back in 2007, with an average price of over $500K meaning you’d need to be clearing six figures to afford your $2,800 a month mortgage payment. It has more than tripled since then and at this rate might catch up with Toronto soon!

Despite the challenges in affordability that persist in the GTA, we are actively working with both buyers and sellers to help find the path forward.  If you’re thinking about a move and want to understand your options, then we’d invite you to get in touch!