How variable and fixed mortgage interest rates are determined
In this article we will clarify how variable and fixed mortgage are determined by financial institutions. Most borrowers incorrectly believe that a rate announcement by the Bank of Canada means that all interest rates are affected and or a rate announcement by one financial institution will affect all other financial institutions’ interest rates. This article will help you to differentiate properly between fixed and variable rates and how they are determined.
VARIABLES RATES
Variable interest rates are affected by changes in the Bank of Canada (BOC) overnight rate and the financial institution’s prime lending rate. Financial institutions normally use the BOC overnight rate to determine their own prime lending rates. To determine the borrower’s variable rate, the financial institution either charges a premium to their prime rate or grants the borrower a discount to their prime rate based on market conditions, their forecasts, etc. E.g. Prime -0.6% means the financial institution grants the borrower a discount of 0.6% to its prime lending rate. The discount to the prime rate is applicable for the length of the mortgage term.
The Bank of Canada meets 8 times a year, at pre-announced dates, to set the overnight rate in response to market conditions to steer the Canadian economy in a desirable direction. Thus, while the Bank of Canada’s decisions can affect the market, the Bank of Canada’s decisions are usually based on the state of the Canadian economy and/or to correct the economy.
The interest rate at which major financial institutions borrow and lend one-day (or overnight) funds amongst themselves. The overnight rate is often referred to as the Bank of Canada’s policy interest rate.
The interest rate a financial institution uses as a base rate to determine interest rates for loan products. Each financial institution sets its own prime rate, as a function of its cost of funding.
- While most financial institutions have the same or very similar prime rates in order to stay competitive with each other, financial institutions are not obligated to have the same prime rates; it is up to each financial institution to determine its own prime rate.
- Although financial institutions usually reduce their prime rate when the BOC reduces its overnight rate, financial institution don’t have to pass on the savings to borrowers and if they do, they are not obligated to pass on the entire savings from the overnight rate reduction to consumers.
- BOC Overnight Rate: Set by the BOC 8 times per year.
- Financial Institution’s Prime Rate = BOC overnight rate + Financial Institution’s profit.
- Variable Rate = Financial Institution’s Prime Rate + Premium/- Discount
- Bank of Canada Overnight Rate: 1.25%
- Financial Institution’s Profit: 2.2%
- Financial Institution’s Prime rate: 1.25% + 2.2% = 3.45%
- Actual Variable Rate P-0.65%: 3.45% – 0.65% = 2.8%
- Thus: P-0.65% = 2.8%
Thus, depending on the borrower’s variable rate mortgage product, variable rates are affected when the BOC overnight rate changes and/or the financial institution changes its prime rate.
Dates: From 2 January 1980 to 16 March 2020
As of 16 March 2020: 0.75%
Highest Rate: 20.99% | Occurred the 1st time in August 1981
Lowest Rate: 0.25% | Occurred the 1st time in April 2009
Average Rate: 5.41%
Current rate is more than 600% below average.
FIXED MORTGAGE RATES
Mortgage fixed rates are largely determined by the bond market. Financial institutions use mortgages and government of Canada bonds to generate profits for themselves. Bonds are debts with a promise to repay the debt principal and interest and bonds serve as security for financial institutions against mortgage losses.
Fixed rates tend to be strongly linked to the bond market. Almost every time, when bond rates go up, fixed rates do the same. Long term mortgage rates tend to be based on the yield. The more lucrative the bond market yield, the lower their fixed mortgage rates tend to be.
From this, we can see that market influences cause financial institutions to set fixed mortgage rates and NOT the Bank of Canada (BOC), nor the government of Canada.
When it comes to fixed mortgage interest rates, it is important to differentiate between actual/discounted fixed interest rates and posted interest rates.
There is a very large distinction between posted and discounted rates. Most borrowers neither understand, nor pay attention to their mortgage’s posted rate, because it is not the actual interest rate applied to their mortgage. However, the posted rate is extremely important since financial institutions use their posted rates to calculate mortgage pre-payment penalties when borrowers pre-pay or “break” their mortgage before the mortgage’s term matures. The payout penalty is largely determined by the difference between the financial institution’s posted rate for the remaining mortgage term and the actual mortgage interest rate that the borrower pays. The bigger the difference between the posted rate and the actual rate, the bigger the penalty the borrower will have to pay to exit the mortgage. From this it can be seen that posted rates are used by financial institutions to make it hard if not impossible for borrowers to move their mortgages to different financial institutions or realize potential savings from lower interest rates. Note: Not all financial institutions have the same posted rates; look for financial institutions with a consistent history of lower posted rates. Financial institutions also use their posted rates to qualify borrowers for mortgages.
The Bank of Canada (BOC) tracks the most typical posted rates offered by Canada’s biggest 6 major chartered banks as the “Chartered Bank Interest Rates – Conventional Mortgage”. While the posted rates are always higher than the actual mortgage rates, they are useful to track as a trend for fixed rates.
Dates: From 2 January 1980 to 16 March 2020
As of 16 March 2020: 5.19%
Highest Rate: 21.75% | Occurred the 1st time in August 1981
Lowest Rate: 4.64% | Occurred the 1st time in April 2015
Average Rate: 8.63%
Current rate is more than 66% below average.
As we can see not all things are equal when it comes to obtaining a mortgage. Work with a professional who specializes in mortgages only. The right mortgage broker will help you to spend less and create wealth.