Whether fixed or variable, mortgage interest rates are determined primarily based on changes to the Bank of Canada (BoC) policy rate and bond yields. The policy rate is the benchmark lenders use to set their interest rates for variable loans, mortgages, and other lending products. 

Fixed and variable mortgage rates are generally higher than the BoC policy rate or corresponding bond yield. This is because lenders are businesses that aim to make a profit from the funds they lend to borrowers. Other borrowing expenses and added risks are associated with lending money for mortgages. As a result, these costs and risks are factored into the higher interest rate lenders offer borrowers.

Key Takeaways

• The BoC policy rate influences variable-rate mortgages, while bond yields influence fixed-rate mortgages.
• Fixed and variable mortgage rates are higher than the policy rate or bond yields to compensate for risk and lending expenses.
• The Bank of Canada adjusts the policy rate on 8 dates each year, impacting variable and indirectly fixed lending.

How Are Mortgage Rates Determined?

When lenders determine the mortgage rate offered to you, they consider several factors. These include the Bank of Canada (BoC) policy rate, bond yields, personal factors like your credit score, loan-to-value (LTV) ratio, downpayment, and more. 

Variable-rate mortgages are directly linked to the policy rate set by the Bank of Canada. When the policy rate changes, lenders adjust their prime rates accordingly. Typically, financial institutions maintain prime rates at a difference of 2.20% higher than the BoC policy rate. For example, if the BoC policy rate is currently 4.50%, you can anticipate that most lenders will have a prime rate of 6.70%. 

Lenders’ posted variable rates combine the prime rate plus a premium or minus a discount. For example, you may see a 5-year variable interest rate a lender is advertising as prime + or – 0.50%. If the lender’s prime rate is currently 6.70%, a premium will mean the 5-year variable rate advertised is 7.20% (6.70%+0.50%), while a discount will mean the rate is 6.20% (6.70%+0.50%). 

Fixed-rate mortgages are determined based on bond yields corresponding to the mortgage’s maturity date. Bond yields are indirectly influenced by predictions of what the BoC may do with the policy rate in the future. 

In the event of high inflation or bad news, bond prices may fall, and bond yields will increase because traders expect the policy rate to increase at the next BoC policy rate announcement. If inflation is low or good news is expected, bond prices may increase, and bond yields will fall as traders expect the policy rate to decrease at the next announcement. 

Typically, fixed rates are priced at a 1% to 2% higher premium than the corresponding bond yield. For example, if the 5-year bond yield is currently 3.20%, you can anticipate that 5-year fixed rates will range from 4.20% to 5.20%, depending on the lender. 

Who Determines Mortgage Rates?

Mortgage rates are determined by lenders who base their prime rates on the relevant influencing factor (bond yields or the BoC policy rate).

Interest rates for fixed mortgages are determined based on the movement of bond yields with corresponding maturities. For example, 5-year bond yields will determine 5-year fixed mortgage rates, 3-year bond yields will determine 3-year fixed mortgage rates, etc. Due to the increased risk and expenses of lending money, lenders typically set these rates higher than the bond yield to compensate for this risk. 

Interest rates for variable mortgages are determined based on changes made to the BoC policy rate that lenders then use to set their prime rates. Prime rates are typically priced higher than the policy rate to factor in the additional costs and risks associated with mortgages. 

Lenders also consider the length of the mortgage term, amortization, prime and posted rates, type of mortgage, and subject property use when setting their posted mortgage rates. Your credit score, income, LTV ratios, relationship with the lender, and other factors could qualify you for a discount on the posted rates. 

The Role of the Bank of Canada in Determining Mortgage Rates

The BoC influences short-term interest rates through monetary policy. The main goal is to keep inflation within the 2% target to protect the value of the Canadian dollar. The BoC sets the target overnight rate (policy rate) to stabilize inflation and the economy. This is the rate that lenders are expected to use as the benchmark for rates for their variable lending products. 

Factors That Impact Mortgage Rates

The economy impacts interest rates, both in Canada and globally. Economic stability in Canada, as measured by inflation data, is a significant influencer that the BoC uses to make policy rate decisions that impact mortgage rates. 

This relationship between inflation and interest rates typically follows a similar pattern. When inflation is high, interest rates increase to control and bring it back to target. When inflation is low, interest rates decrease to boost the economy and encourage borrowing and spending. 

How Interest Rates Affect Home Affordability

Interest rates typically have an inverse relationship with home affordability. However, housing supply and demand have a much more profound impact on home affordability. 

When interest rates increase, it becomes more difficult for borrowers who need a mortgage to purchase a home. As interest rates rise, borrowing costs increase, meaning higher mortgage payments. This decreases purchasing power and can reduce demand for homes if fewer buyers qualify for a mortgage. If fewer buyers are in the market, sellers may be more motivated to lower prices to attract borrowers. 

When interest rates decrease, this can improve affordability for borrowers who need a mortgage. This reduces the cost of borrowing, meaning lower mortgage payments. Borrowers can now afford more as their money goes further. As a result, this can increase demand for homes as more buyers are now in the market, and sellers may be more willing to hold out for higher offers and increase prices when demand is higher. 

How Lower Interest Rates Affect the Economy

When inflation is below the 2% target, the BoC reduces the policy rate, which prompts lenders to do the same, decreasing their prime rates. Lower interest rates boost the economy as they encourage borrowing and spending. 

Increased borrowing and spending in the economy results in a greater need for goods and services. As a result, the cost of purchasing these items increases due to the difficulty of maintaining enough supply to meet the high demand. This can lead to inflationary pressures that could potentially cause inflation to rise. This may trigger the economic cycle that Canada has historically experienced every 5 to 7 years. 

How Higher Interest Rates Affect the Economy

When inflation becomes excessively high, the BoC raises the policy rate, which prompts lenders to raise their prime rates. Higher interest rates discourage borrowing and spending to curb inflation, decreasing disposable income and restricting economic growth. 

Reduced borrowing and spending decrease the demand for goods and services. This allows supply to catch up and leads to a more gradual price increase or decrease (such as sales) to stimulate demand. This helps alleviate inflationary pressures and helps bring inflation back down. There is a possibility of entering a recession when interest rates are raised quickly without providing enough time for the economy to react and adjust. 

How Are Stress Test Rates Set?

The Office of the Superintendent of Financial Institutions (OSFI) sets stress test rates. This test evaluates your ability to make mortgage payments if interest rates rise. Stress test rules set a minimum qualifying rate (MQR) of 5.25% or your contract rate plus 2%, whichever is higher. 

5.25% is considered the “floor” and is set considering the potential risks associated with economic changes. This rate is set through an analysis of the financial vulnerabilities of borrowers and financial institutions regulated by the federal government, which could lead to mortgage defaults or impact the financial system. Your contract rate +2 is considered the “buffer,” which adds a margin of safety to assess a borrower’s ability to handle changes such as rising mortgage rates or changes in income. 

If interest rates +2% are lower than the floor, you will be stress-tested at 5.25%. For example, when interest rates were at all-time lows, if you were offered a rate of 1.75%, this rate +2% is 3.75%, meaning you would have been stress-tested at 5.25%. If interest rates +2% are higher than the floor, you will be stress-tested at that rate. For example, now that interest rates are high, if you are offered a rate of 4.89%, this rate +2% is 6.89%, meaning you will be stress-tested at 6.89%.

Frequently Asked Questions

Final Thoughts 

The policy rate and bond yields impact the cost of mortgages. When the BoC changes the policy rate, it immediately impacts variable-rate mortgages, as lenders adjust their prime rates quickly after an announcement. Fixed-rate mortgages change with changes to bond yields and tend to take longer to adjust. 

Mortgage rates can increase or decrease at any time, so it’s recommended that you monitor the economy’s state closely. Knowing what influences mortgage rates can help you make better financial decisions regarding your mortgage. 

If you’re looking to secure financing for a new home or renew at a lower rate, contact our mortgage professionals for tailored advice.