How do major banks price 1-year mortgages?

All fixed-rate mortgages are influenced by the bond market. Mortgage lenders invest in bonds and mortgages for profit. The profits are then recycled to purchase more bonds and issue more mortgages. Here's a list of the sources lenders rely on to finance mortgages:

• Bank deposits
• Mortgage-backed securities
• Deposit notes
• Canada mortgage bonds
• Covered bonds
• Five-year swaps
• Investor purchases

To figure out the interest amount to charge on a fixed-rate mortgage, lenders look to the interest they're earning on bond investments.

The government bond market in Canada broadly dictates fixed-rate mortgage rates. A five-year fixed rate, for instance, will track the five-year Government of Canada bond.

When bond yields rise, so do fixed-mortgage rates.

In the two years following the emergence of the COVID pandemic, Canada's economy expanded beyond economists' expectations. Consumer demand for goods (including houses) was overwhelming, causing inflation to rise. In 2022, the Bank of Canada began an aggressive rate increase strategy to help bring down demand and inflation.

The Bank of Canada's decision to raise overnight rates led to a rapid surge in bond yields. As the bank drove up the cost of borrowing, the interest paid on bonds began going up, and mortgage rates quickly followed.

This was a stark reversal from late 2020 to early 2021, when bond yields and, conversely, mortgage rates bottomed. Mortgage lenders offered some of the lowest mortgage rates in history during this period.

Inflation is expected to decrease gradually due to higher policy interest rates and rising long-term bond yields, which are dampening demand.

Several factors contribute to the rise in long-term bond yields, including increased real yields, a rising term premium, fiscal deficits, and changes in the neutral interest rate.

The Bank of Canada’s monetary policy tightening has also affected global financial markets, potentially impacting equity and asset prices, which, in turn, can influence investment and consumption, both domestically and internationally.

The Bank of Canada has increased interest rates 10 times since March 2022, leading to a slowdown in mortgage credit growth and reduced demand for housing and big budget items, resulting in a 33% drop in housing resales and a 10% decrease in house prices since February 2022.

Concisely, prices are going down a bit, it's more expensive to borrow money, and the housing market isn't as hot as it used to be. This is all because of actions taken by the government to control the economy.

Pros and cons of 1-year fixed rate mortgages

Advantages of a 1-year fixed mortgage

Here's the upside to choosing a 1-year fixed mortgage: 

• Lower rates compared to longer terms: Shorter terms often offer better pricing than longer terms. In the case of one-year rates, they can be a decent discount compared to two and three-year terms. They're also a great alternative to a floating rate when variable discounts are small by comparison, as was the case in the spring and summer of 2020. 
• Less chance of paying prepayment penalties: For those unsure about their near-term life plans, locking into a longer fixed term can result in significant penalties should you break your mortgage early. With a one-year term, the odds of needing to break your mortgage before the end of the term are significantly reduced. 
• Good for those who only need a short-term mortgage: A one-year term can be ideal if you only need a mortgage for roughly 12 months. Typical examples include property flips, credit rehabilitation and people with short remaining amortizations.
• Those who expect rates to fall within 12 months: A 1-year fixed mortgage can be a great interim solution for borrowers who expect mortgage rates to fall in the next year. A one-year term allows them to shop the market in just 12 months. This is especially useful when variable-rate discounts are historically small.

Cons of a 1-year fixed mortgage: 

The following are some of the potential drawbacks of choosing a 1-year fixed mortgage: 

• Little protection against rate hikes: If rates jump, you're not protected as you would be with a longer fixed term. 
• Renewal hassle: Many people choose slightly higher rates for a longer term, such as the five-year mortgage, to avoid the perceived hassle of renewing their mortgage annually. A one-year term may be a good one-off option depending on your circumstances, but choosing one-year terms regularly can indeed become a headache at renewal time. 
• Switching costs: If you opt for short terms such as the 1-year fixed— particularly for consecutive terms — you are more likely to face switching costs if you frequently change lenders.