How Mortgage Rates Are Determined

Chances are you’ve heard of the two most common mortgage product types: fixed and variable (sometimes called adjustable).

But did you know that interest rates for each type are determined by different factors?

While both fixed and variable mortgage rates are impacted by a consumer’s financial health, they are also affected by two distinct largescale economic factors. These factors include activity by the Bank of Canada and by the Government of Canada. Here’s how it works.

What determines variable mortgage rates?

Variable mortgage rates are short-term interest rates that fluctuate in tandem with a lender’s prime rate. Prime rates are most influenced by the Bank of Canada’s “overnight” rate, also called its “policy interest rate.”

The overnight rate is the interest rate at which major financial institutions borrow and lend one-day (or "overnight") funds among themselves. They settle their accounts at the end of each business day based on this rate. Eight times a year, the Bank of Canada – or BoC – influences short-term interest rates (like variable mortgage rates and lines of credit) by raising or lowering the target for the overnight rate. This is how the BoC carries out its monetary policy in an effort to keep the economy stable.

When the BoC increases the overnight rate, it becomes more expensive for banks to borrow money. As a result, their prime rate goes up to cover the added costs. When the BoC lowers the overnight rate, banks typically follow suit and lower their prime rate, passing the discount down to their customers. While each lender sets its own prime rate, there is usually consistency across the “big six” banks.

Key takeaway: The overnight rate set by the Bank of Canada is the biggest factor that determines whether interest rates on variable mortgages will go up or down. When the overnight rate increases, variable mortgage rates can be expected to increase as well.

What determines fixed mortgage rates?

Fixed mortgage rates largely depend on Government of Canada (GoC) bond yields. The relationship between fixed mortgage rates and GoC bond yields isn’t firm, but it is positive: meaning that when GoC bond yields go up, fixed mortgage rates tend to go up as well. Why? It’s a matter of risk, supply, and demand.

Because they are guaranteed to be repaid, GoC bonds are considered an ultra low-risk long-term investment product. In comparison, mortgages carry a higher risk (after all, there is a chance that the return on investment could be reduced if a borrower defaults or repays the loan early). Pricing fixed mortgage rates slightly higher than GoC bond yields serves to attract investors by compensating for this higher risk.

At its most basic, when the economy is judged to be weak, safer investments like GoC bonds become more popular. This demand drives GoC bond prices up, which creates lower yields and lowers fixed mortgage rates in response. When the economy is considered strong, investors feel comfortable taking on more risk, and bond demand falls, causing yields to increase and fixed mortgage rates to go up to compete. Factors that influence whether the economy is weak or strong include inflation, employment rates, and consumer spending.

Key takeaway: The performance of Government of Canada bond yields gauges whether fixed mortgage rates will go up or down. The relationship between bond yields and fixed rates is largely positive – when yields go up or down, so do rates.

How does personal financial health factor in?

While Government of Canada bond yields and the Bank of Canada overnight rate are broad indicators of how fixed and variable mortgage rates will behave at a macro level, it’s important to remember that there are micro factors at work too.

The interest rate that is finally offered from a lender to a consumer is also determined by factors unique to each transaction, such as the property type and its value, the down payment, credit scores, employment, the bank’s balance sheet, the bank’s mortgage products, and more. The only homebuyer who will receive the prime rate is a “prime” customer – someone deemed creditworthy based on all the factors above. For this reason, it’s essential to talk to a mortgage advisor who can review your financial health, advocate on your behalf, and find the best rate and best terms for your unique situation.

Key takeaway: Whether your mortgage is fixed or variable, your financial health will ultimately determine your interest rate. For the best advice, speak to a mortgage advisor.

What’s next for mortgage rates in Canada?

While different factors determine the interest rates for different mortgage types, broadly speaking all interest rates follow fluctuations in Canada’s economic performance. With the third vaccine rollout underway and our economy performing better than many analysts anticipated, we can expect long-term (fixed mortgage) interest rates to rise incrementally as demand for bonds falls and investors take more risks. Until the Bank of Canada deems the economy stable enough to lift the overnight rate, we can expect short-term (variable mortgage) interest rates to remain low. The overnight rate has remained at 0.25 per cent since March 2020.

The Bank of Canada’s next interest rate announcement is set for January 26, 2022.