In Canada, fixed mortgage rates are affected largely by bond yields, while variable mortgage rates are affected by prime rates. Changes in bond yields and prime rates can cause mortgage rates to rise or fall. However, other factors can affect the mortgage rate that applies to you. This can include your financial situation, the mortgage type and length, your location, and the property being mortgaged. This page will take a look at how mortgage rates are determined in Canada, as well as what affects them.
Fixed-rate mortgages, and changes in their interest rates, are based on bond yields. A common comparison is to look at the 5-year Government of Canada bond yield for 5-year fixed mortgage rates. When the bond yield rises, so does fixed mortgage rates. When it falls, fixed mortgage rates typically follow suit. While they don’t follow each other exactly, this is the general relationship between fixed mortgage rates and bond yields.
Typically, 5-year fixed mortgage rates are priced 1% to 3% higher than the 5-year Government of Canada bond yield. This is known as the spread, or markup, between fixed rate mortgages and bond yields. The reason for this has to do with the different levels of risk associated with the two investments from a lender’s perspective.
Government of Canada bonds are considered to be “risk-free”, because they are backed by the government, which has various tools and measures in place to avoid defaulting on their debt. On the other hand, mortgages are not risk-free. While they are secured by property, there is a chance that borrowers would not repay their mortgage. According to the Canadian Bankers Association, 0.15% of all mortgages in Canada were in arrears in November 2022, which are mortgages that haven’t been paid in three months or more.
When deciding where to invest their money, let’s assume that banks and financial institutions can only decide between government bonds and mortgages. Since there is no risk for banks to invest in government bonds, they will need to receive a greater return on their investment in order to consider lending out their money to mortgages, where they are risking losing some of their money. That’s why mortgage rates are higher than government bond yields.
Comparing the spread between mortgages and bond yields also requires the same time period. It’s common to compare 5-year fixed rate mortgages, the most popular type of mortgage in Canada, with the 5-year Government of Canada bond yield. That’s because the bank’s money would be locked up for the same amount of time. It wouldn’t make sense to compare the spread between a 5-year fixed rate mortgage and the 10-year bond yield, as the bank’s money would be locked up for longer with the 10-year bond. Instead, you might compare 10-year fixed mortgage rates with the 10-year bond yield.
You might see 5-year fixed mortgage rates compared to the 4-year bond yield, instead of 5-year bond yields. That’s because some mortgage borrowers won’t keep their mortgage for the entire 5-year term. Some might renew their mortgage early, refinance their mortgage, or even pay off their mortgage early. This reduces the average length that a borrower holds a 5-year mortgage. In order to keep the duration of each option the same, 5-year mortgages can be compared to 4-year bonds.
Fixed mortgage rates generally follow bond yields, but changes in bond yields might not lead to an instantaneous change in mortgage rates. Bonds are traded on the market and so the yield of bonds can change constantly, as bond prices go up or down. Meanwhile, mortgage rates are set by banks and lenders. If bond yields rise consistently, then you can expect fixed mortgage rates to rise. The opposite can happen too. If bond yields fall, then you can expect fixed mortgage rates to decrease. The timing and amount of mortgage rate changes might be different, but fixed mortgage rates usually stay within the spread range of 1% to 3% above their same-maturity bond yields.
Variable mortgage rates are based on the prime rate. Each bank also sets their own prime rate, but they are generally the same between banks. Unlike fixed mortgage rates, which has an interest rate that stays the same for the term of the mortgage, a variable mortgage has a rate that can change. Variable rates are based on the prime rate by having a spread based on it. For example, you might have a variable rate of Prime + 0.5%. If the current prime rate is %, then your variable rate would be %. If the prime rate increases, your variable mortgage rate will increase by the same amount.
While changes in the prime rate causes variable mortgage rates to rise or fall, what exactly causes prime rates to change? The answer lies with the Bank of Canada, which sets an overnight policy interest rate. The Bank of Canada announces any changes in this rate at eight meetings per year. If the Bank of Canada rate increases, then banks will increase their prime rate. That’s because an increase in the Bank of Canada rate will make it more expensive for banks to borrow money. They pass this increased cost to their own borrowers by hiking their prime rates. A high inflation rate will cause the Bank of Canada to increase rates, which will work its way through the market in the form of higher mortgage rates.
Rate cuts by the Bank of Canada will generally lead to a decrease in prime rates too. However, banks aren’t required to fully match the increase or decrease in the Bank of Canada’s rate changes. It’s possible for the Bank of Canada to announce a rate cut, but for banks to leave their prime rates unchanged.
While prime rates don’t directly affect fixed mortgage rates, the cause of prime rate changes may indirectly affect fixed mortgage rates. Bank of Canada rate changes, the cause of prime rate changes, can impact bond yields, which may then affect fixed mortgage rates.
Things like bond yields and prime rates might be out of your control, but you can also affect your mortgage rate in other ways. Here are a few ways that you can affect your mortgage rate:
A bad credit score can increase your mortgage rate above what someone with a good credit score might have. A bad credit score might even disqualify you from some lenders, and force you to use private mortgage lenders with high mortgage rates. Rebuilding your credit can help lower the mortgage rate that you qualify for.
A lender will take into consideration your income when determining your mortgage rate, which also affects things like your debt service ratios. A higher income can reduce the mortgage rate that you qualify for.
Compare mortgage rates from different lenders, or consider using a mortgage broker, to get the best possible rate. Some lenders may also offer long rate-hold periods where you can lock-in a certain mortgage rate. This protects you from changes in mortgage rates before approval.