Factors That Influence Variable and Fixed Canadian Mortgage Rates

The turbulent past few weeks in the global economy has been playing havoc with interest rates as the Bank of Canada was among several global central banks to drop their prime lending rates to try and slow down the economic downturn. The typical reaction from the Big Banks is to follow the Bank of Canada’s lead and decrease their Prime Rates - by a similar amount, although that didn’t happen last week. Royal Bank, TD and Scotiabank, along with the rest only dropped their Prime rate by 0.25% versus the 0.50% decrease by the Federal government. This resulted in Canadian mortgage rates actually increasing which again goes against normal market behaviour. This results in a very interesting question – what actually affects Canadian mortgage rates?

There are numerous factors that influence Canada’s economy including unemployment, gas prices, inflation, exports and imports, the government budget deficit or surplus and the list goes on, and it can be difficult to keep track of all these things and how they impact our daily lives and the mortgage rates we have to pay. Many people believe that the Bank of Canada’s monthly interest rate decisions directly affects all mortgage rates, but that’s not the case. Variable (ARM or adjustable mortgage rates) and fixed mortgage rates in Canada are actually influenced by different factors.

Canadian fixed mortgage rates are affected by the price of government bonds and the bond yield. Bonds are typically considered safer investments than stocks, and when there is economic turmoil, investors usually will dump equities in favour of bonds, especially Government bonds, and when the stock market is booming, investors most likely would make a higher return on investment in equities.

This means there is a lower demand for bonds, so they decline in value and increase their yield. On the other hand, when the Canadian economy becomes less stable and stocks do not look as enticing, the demand for bonds increases and their yields decrease.

When the Canadian government’s longer term bond prices, such as the 5 year increase, this results in a decreased yield (return), typically reducing the five year borrowing costs for mortgage lenders who can then pass these savings onto customers in the form of lower 5 year fixed mortgage rates.

However, during these very unusual times, due to the lack of liquidity in the markets, banks around the world are hesitant to lend to each other and are hoarding cash, resulting in higher borrowing costs and lenders have to pass on these increased on to customers in the form of higher fixed mortgage rates.

The Bank of Canada plays a big part in determining variable mortgage rates as they set the target overnight target rate which they describe as:

“the average interest rate that the Bank wants to see in the marketplace for one-day (or "overnight") loans between financial institutions.”

This is what the Big Banks based their Prime Rates on and the Bank of Canada doesn’t have any say in setting lender’s Prime Rates, they are determined by each financial institution independently and are based on the cost of short-term funds.

This is important as variable mortgage rates are advertised as Prime – 0.60% or similar, which means that the interest rate you’ll pay is directly related to the Prime rate, and will fluctuate whenever this changes. So, if the Bank of Canada drops rates by 0.50% or 50 basis points as they did last week, lenders usually decrease their Prime rate as well, as their cost of borrowing drops, meaning that your payments on a variable rate mortgage will decrease, a great option if interest rates are falling.

The problem with this scenario during this dreaded ‘credit crunch’ is that banks have stopped lending to each other in the short term as they’re scared they may not get their money back due to the instability in the system. As a result, interbank lending rates have increased and this higher cost is being passed onto customers in the form of higher interest rates.

This is a very common question and really depends on each person’s situation and whether they can handle the changing mortgage rate payments, both financially and mentally, because the last thing you want to do is lose sleep because interest rates may increase, or if you’d feel more comfortable knowing the constant fixed rate you’d be paying over a few years.

There have been many studies and debates on which is better for borrowers and the analysis shows that historically Canadian homeowners would be better off by choosing variable rates. There was a recent report released by Dr. Milevsky, associate professor of finance, Schulich School of Business, York University, and he said that based on data from 1950 to 2007, the average Canadian could expect to save interest 90.1% of the time by choosing a variable-rate mortgage instead of a fixed. The average savings was $20,630 over 15 years per $100,000 borrowed, and he stated "over the long run, homeowners really do pay extra for fixed-rate mortgages."

This may be something to keep in mind over the next few months as the Bank of Canada is forecasted to decrease mortgage rates, but keep in mind these are very unusual times and the best thing may be to expect the unexpected.