The absolute chaos in the global financial markets over the past few weeks with the US $700 billion bailout plan, Lehman Brothers going bust, European banks being nationalized and some governments guaranteeing customer deposits is starting to hit home as mortgage rates have recently increased– which leads to the very interesting question – what actually affects Canadian mortgage rates?
There are so many factors that influence the economy and ultimately lenders and the amount they charge on home loans, including unemployment, inflation, consumer confidence and the oil price to name a few that it can be extremely difficult to keep all these metrics straight in your head.
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.
Variable mortgage rates
The Bank of Canada actually does play a large role in determining variable mortgage rates as they determine 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. Changes in this rate influence other interest rates, such as those for consumer loans and mortgages.”
This is what lender’s prime rates are based on and the Bank of Canada doesn’t actually set the prime rate as these 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, your lender will most likely decrease their prime rate as well, meaning that your mortgage payments will decrease. Obviously, this type of mortgage is 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.
Fixed mortgage rates
The Canadian government plays another central role in the fixed mortgage rate market, specifically the price of government bonds, and these interest rates are influenced by the bond yield.
Bonds are typically considered safer investments than stocks, especially government bonds, and when the stock market is booming, investors most likely would make a higher return on investment in equities, which 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. As a result, when the government of Canada’s longer term bond prices, such as the five-year increase, this decreases the yield, typically reducing the five year borrowing costs for mortgage lenders who can then pass these savings onto customers in the form of lower five-year fixed mortgage rates.
However, during this unprecedented economic time, due to the lack of liquidity in the markets, where banks around the world are hesitant to lend to each other and are holding onto their own cash, banks have had to pass these increased these higher costs to customers in the form of higher fixed mortgage rates.
Lock in your mortgage rate
If you are looking to buy a house in the next few months or need to refinance soon, you may be interested in additional security offered by locking in your mortgage rate. You can do this by going to a lender or broker and get ‘pre-approved’ which means that you have access to that rate, regardless of any other factors, for a specified period of time. Speak to your lender or mortgage broker as many offer rate guarantees of up to 120 days.
What will save me more money – fixed or variable rates?
There have been many studies and debates on which is better for borrowers -- variable mortgage rates or fixed mortgage rates.
The analysis states 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 expected to decrease mortgage rates.
However, as we stated earlier, we are currently seeing things that have never happened before and the markets aren’t behaving as they normally do, so make sure to get expert advice before making any decisions.