Understanding mortgage rates

September 1, 2021

The influence of the Bank of Canada, in tandem with the markets, influence your mortgage rates. The following are excerpts from the Bank of Canada website:

Buying a home is probably the biggest purchase you’ll ever make. If you’re like most people, you won’t pay cash—you’ll borrow most of the money by taking out a mortgage. And over the life of the mortgage, you’ll pay a lot in interest. Small changes in interest rates can make a big difference in how much you’ll pay. So it’s important that you understand what determines the interest rate on your mortgage, even if you already own a home. Many factors go into the interest rate you pay. 1

Think of a mortgage as a product you buy. Any business that sells you something tries to make a profit. To do that, the price they charge for the product has to be higher than the cost to make it. A lender profits on your mortgage because you pay more in interest (the price it charges) than what they paid to borrow the money themselves (their funding cost).1

This funding cost makes up most of the interest rate on your mortgage. Other factors include your lender’s operating costs and how much the lender needs to cover the risk that you won’t repay the loan. But funding cost is the most important factor.1

So, what determines funding cost? The Bank of Canada doesn’t set mortgage rates. But it does have some impact on them. When the economy is strong, we may raise this rate to keep inflation from rising above our target. Likewise, when the economy is weak, we may lower our policy rate to keep inflation from falling below the target. Changes in the policy interest rate lead to similar changes in short-term interest rates. These include the prime rate, which is used by the banks as a basis for pricing variable-rate mortgages. A policy-rate change can also affect long-term interest rates, especially if people expect that change to be long-lasting.1

In the past, high and variable inflation eroded the value of money. In response, investors demanded higher interest rates to offset those effects. This increased funding costs for mortgage lenders. But since the Bank of Canada began targeting inflation in the 1990s, interest rates and uncertainty about future inflation have declined. As a result, funding costs are now much lower.1

Your past credit history and some of the features you choose for your mortgage determine how much risk lenders face when lending to you. More risk means a higher interest rate. 1

Repayment relates to your credit risk. The most important risk for the lender is that you won’t repay the loan. A high credit score can help lessen this concern, as it shows the lender you’ve been good at repaying your debts. So, you may pay a lower interest rate than those who have a lower score. 1

If your mortgage is worth more than 80 percent of the value of the home, you’ll have to buy mortgage default insurance. But since insurance protects the lender from the risk of default, you may get a lower interest rate than if you go for an uninsured mortgage with a bigger down payment. 1

Interest rate risk. Most mortgage loans in Canada are renegotiated every 5 years, but they can be as short as 6 months or as long as 10 years. The more often you renegotiate, the more often you face the risk that the new interest rate will be different from the old one. If you are more comfortable with having your rate fixed for as long as possible, prepare to pay a premium for that peace of mind. 1

Prepayment risk. The lender risks losing money if you repay your mortgage early—known as prepayment risk. That’s because the lender won’t be able to profit as much from the funds they raised, particularly if interest rates have dropped since the mortgage started. So, an “open” mortgage, which lets you repay all of the loan early, usually has a higher interest rate than a “closed” mortgage, which limits how much you can prepay. 1

Source: Bank of Canada

 

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