Mortgages are complicated. There are different types, terms, rates, and rules – not to mention trying to understand how the bond market affects mortgage rates. Rates seem to change on a whim, leaving homeowners – or first-time homebuyers – uncertain about what to expect when it’s time to get or renew a mortgage.
When it comes to interest rates, the key player is the Bank of Canada, which sets the overnight interest rate that is used to determine every bank’s prime lending rate and affects borrowing costs on variable-rate mortgages and other loans.
But fixed-rate mortgages aren’t as directly tied to what the central bank does. Instead, they are determined based on what the bond market is doing, says Rob McLister, mortgage strategist and editor at mortgagelogic.news.
How does the bond market affect mortgage rates?
When lenders, like banks, set rates, they look at their cost to borrow funds – through deposits, securitization or other avenues – “then they tack on other expenses like overhead and commissions, then they add a profit. They set their rates to cover all those items,” McLister explains.
“Funding costs are benchmarked to yields in the bond market. Most people watch Canada’s five-year bond yield for hints at where fixed rates might go,” he adds.
For example, in early November, the five-year Government of Canada bond yield was 3.12 per cent and five-year mortgage rates ranged from 3.99 per cent to 4.75 per cent on rate comparison site ratehub.ca.
“Lenders try to maintain a given spread (or profit margin) above their cost of funds,” McLister says.
“For five-year fixed mortgages, deep discount bank rates have averaged roughly 155 basis points (a basis point or bps is 1/100th of a percentage point) over the five-year government bond yield. That’s measured over the last five years.”
Insurance, down payments and other variables
Ben Rabidoux, founder of Edge Realty Analytics Ltd., says another twist is if you have an insured or uninsured mortgage, depending on if you have a downpayment of 20 per cent or less. Those without a high enough down payment will need to get mortgage insurance, which is backed by the government, and can mean a bank will give you a lower mortgage rate due to that insurance.
Those rates can fluctuate slightly depending on the outlook for the economy, he notes, and they’ll increase “during periods where there’s economic stress and then they’ll narrow when the economy is doing well.”
Variable-rate mortgages – whose interest rate can change based on the bank’s prime rate – are often priced as a percentage off the prime rate, such as prime minus one per cent, McLister says.
The catch with some variable-rate mortgages with fixed or static payments is that the amount of principal you’re paying off with each payment – which is the loan amount not including interest – can fluctuate as interest rates move. That means if rates rise you’re paying more in interest and less in principal and it will take you longer to pay off your mortgage. However, if rates fall, you’re paying more in principal and less in interest and you’ll pay off your mortgage a bit faster.
Some variable-rate mortgages have adjustable payments, which means you pay more each month if rates rise and less if rates fall.
Fixed, variable – and uncertainty
For many people, the roller-coaster effect of rising and falling interest rates, and how long it will take them to pay off their mortgage, is too much to manage. That’s why many homeowners choose to go with a fixed-rate mortgage, especially when it looks like rates may rise in the next few years. However, if rates look like they will be declining, then more homeowners look to variable-rate mortgages.
“It’s a good reason why a lot of people have avoided variable-rate mortgages,” says Rabidoux. “There’s just too much, too many things for them to think about.”
But just to make it even more complicated, McLister notes that “fixed rates don’t always follow bond moves.” Banks or lenders may decide to keep rates steady even when bond yields change, he adds.
“The five-year yield may shoot up 20 bps with no impact on fixed rates because lenders absorb the margin compression. If yields move enough, however, fixed rates will follow,” he says.
If you’re in the market for a mortgage it’s best to keep an eye on where bond rates are currently, and if they start to edge higher you need to make a move yourself.
“If you see yields shooting up, and you need a fixed mortgage, it’s a reminder to lock something in soon,” McLister advises.
