Why do Mortgage Rates Change? What Factors Affect Fixed and Variable Canadian Mortgage Rates?
There are many factors that influence the health of the economy; unemployment, inflation, consumer confidence and the housing market, just to name a few. Let’s take a look at the factors that influence fixed and variable mortgage rates.
Factors that Affect: Fixed Mortgage Rates
The main factor affecting fixed mortgage rates is Government of Canada bond yields. Fixed mortgage rates typically move in alignment with government bond yields of the same term.
Fixed Mortgage Rate: a fixed rate enables you to “lock in” a predetermined rate for a set period of time, or the term, with the most popular fixed term being 5 years.
Bond Prices and Bond Yields (Negative Relationship)
The price of bonds have a negative relationship with bond yields. In other words when bond prices increase, bond yields decrease, and when bond prices decrease, bond yields increase. Bonds are typically considered safer investments than stocks, especially Government bonds and as such bond prices typically decrease when the market is booming, and increase when the market is dipping.
Bond Yield: the return an investor will receive by holding a bond to maturity.
Bond Yields and Fixed Rates (Positive Relationship)
Generally fixed rates have a positive relationship with bond yields and increase and decrease along with bond yields. In other words, when bond yields increase, fixed rates increase, and when bond yields decrease, fixed rates decrease.
The chart below shows the 5-year posted fixed mortgage rates against the 5-year Government of Canada bond yields over the past 10 years. As you can see the bond yields and fixed mortgage rates are closely correlated.
Stock Market is Booming – Bond Prices Decrease, Bond Yields Increase, Fixed Rates Increase
When the stock market is booming, investors are more likely to make a higher return on investing in equities (i.e. the stock market) than investing in bonds. Thus the demand for bonds decreases, meaning that the price of bonds decreases, and the bond yield increases. As such, fixed rates will likely increase.
Stock Market is Dipping – Bond Prices Increase, Bond Yields Decrease, Fixed Rates Decrease
On the other hand, when the Canadian economy becomes less stable and stocks do not look as enticing, investors are more likely to invest in safer investments such as bonds. Thus the demand for bonds increases, meaning that the price of bonds increases, and the bond yield decreases. As such, fixed rates will likely decrease.
Example – 5 Year Bond Yield vs. 5 Year Fixed Rate
For example, if the Government of Canada’s 5-year bond yield increases, the 5-year fixed mortgage rate would normally increase as well. There are some periods where they may not move directly in sync with each other, but this is the general trend.
Factors that Affect: Variable Mortgage Rates
The Bank of Canada is responsible for changes to variable mortgage rates because they determine the target overnight lending rate.
Variable Mortgage Rate: fluctuate monthly and is based on the mortgage lender’s prime rate.
Variable Rates and the Overnight Rate
The overnight rate changes the cost of lending/borrowing short-term funds and therefore influences the Prime Rate. Since variable mortgage rates are linked to prime rates, when prime rate goes up, so will your variable mortgage rate and monthly payments.
Overnight Rate: the interest rate which large banks borrow and lend one-day funds amongst themselves. It is also known as the key interest rate, or the key policy rate.
Prime +/-
Variable mortgage rates are advertised as Prime plus or minus X%, for example Prime –0.60%, which means that the interest rate you pay is directly related to the Prime Rate, and will fluctuate whenever this changes. Link to Prime Rates page for all of the banks.
Example
Let’s say the current overnight rate is 0.5% and the major banks prime rate is 2.50%, and at that time the variable mortgage rate is – 0.50% (thus 2.00%).
If the Bank of Canada increases the overnight rate from 0.5% to 0.75% (an increase of 0.25%), the banks will likely follow suit and increase their prime rate by the same 0.25% to 2.75%. Your variable mortgage rate will thus also change due to this increase in the prime rate, making your new variable mortgage rate 2.75% – 0.50% = 2.25%.
How Much Does a Change in Prime Effect my Mortgage?
To put this in perspective, let’s use the above rate change example on a $250,000 mortgage amortized over 25 years. An increase of 0.5% would result in your monthly payments increasing by $30.40/month. Although this is not a massive increase, you can imagine the effects if rates increase by 2 or 3%.
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