There are many factors that can influence the economy at any time. Some of these factors include inflation, CPI, consumer confidence, unemployment, and commodity prices. To have a full understanding of the economy, you must follow all of the economic indicators on a daily basis. Almost everyone believes that when the Bank of Canada makes an adjustment to the overnight lending rate, then this will adjust all mortgage rates; however, this is not true. Variable interest rates and fixed interest rates are determined by different factors that are not dependent on the overnight lending rate.

How are Variable Mortgage Rates determined?

With variable rate mortgages, the Bank of Canada plays a much larger role in determining prime rate for most major financial firms. The Bank of Canada determines the target overnight 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. Changes in this rate influence other interest rates, such as those for consumer loans and mortgages.”

Lender’s base their prime rate on what the Bank of Canada sets the overnight lending rate as. The Bank of Canada does not decide what each bank sets their prime rate at; however, most major banks will match other banks prime rate. Prime rate is based on the cost of short-term money.

Variable mortgage rates are always shown as a spread above or below Prime Rate. This means that your interest rate is directly related to what prime rate is at anytime, and what the overnight lending rate is. So, if the Bank of Canada raises or decreases the interest rate of the overnight lending rate, then you can expect that prime rate will move as well. When interest rates are declining, then choosing a variable rate mortgage is obviously a better choice.

The problem with Prime rate is that banks had become afraid to lend to each other. This is because banks have become afraid that the other bank may default, and they won’t get their money bank. As a result, this has caused banks to charged a higher spread between the overnight lending rate and the final rate on a variable rate mortgage. Due to the decreased profitability of a variable rate mortgage, banks have changed the spreads of variable rate mortgages from prime minus to prime plus. These new prime plus interest rates are quite a change since most people are accustom to receiving prime minus rates.

How are Fixed Mortgage Rates determined?

The Canadian government and the Bank of Canada plays a major role in setting fixed mortgage rates as well. Fixed mortgage rates are influenced by the major bond yields. Bonds have always been considered a safer investment than equities and stocks. This is especially true when considering Government bonds.
When an economy is booming, most investors will invest in stocks and equities because they will earn a higher rate of return. This causes demand for bonds to decrease, and when bond demand decreases, then the bonds must increase the yields of the bonds to entice investors.
When an economy is in a recession, investors will search for a safe place to store their money. Stocks will decrease or have a negative yield, which will cause investors to put money into bonds. This will cause bond yields to go lower because of the increased demand.

When the economy changes, the government of Canada is forced to increase or decrease long term bond prices. When this happens, it will reduce or increase the lending costs for banks. The banks will then pass on these new rates to borrowers by increasing or decreasing fixed mortgage rates.

However, due to the negative economic climate, banks have had more difficulty raising capital to lend to borrowers. This causes the banks to offer higher yields on their bonds which result in higher lending costs to those who get a mortgage. Since there is so much fear in the economic market, banks have had to pass on these increased costs to the borrowers through higher interest rates.

Locking in a Low Mortgage Rate

When purchasing a new house or refinancing your current mortgage, make sure that you have the additional security by locking in your mortgage rate. You can do this by going to any lender or broker and applying for a mortgage pre-approval. A mortgage pre-approval will lock in an interest rate for you usually for up to 120 days. Speak to your lender directly to see what they have to offer.

Fixed Mortgage Rates or Variable Mortgage Rates; What will save more money for you?

Many people have attempted to make a definitive answer on which mortgage product is better. Many results have determined that historically Canadians would be better off by choosing a variable rate mortgage. An analysis had been completed from 1950 to 2007 that determined that 90.1% of the time, homeowners would save money with a variable rate mortgage; however, this is only based on past results.
A good rule of thumb is that when mortgage rates are low, you should lock in, and when mortgage rates are high, then you should get a variable rate mortgage.

If you are nervous about a fluctuating interest rate, then a variable rate mortgage will keep you up at night; however, if you are willing to take the extra risk, then a variable rate mortgage may be for you.

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