Buying a house will undoubtedly be the biggest transaction of your life. If you’re like most people, you won’t pay cash: you’ll apply for a mortgage that will cover most of the purchase price. And during the term of this loan, you are going to pay a lot of interest.
The slightest variation in rates can greatly change the total amount you will pay. It is therefore important to understand what determines the rate of your mortgage, even if you are already a homeowner.
Many factors influence the rate you pay.
Certain factors affect the cost of all mortgages
You can compare a mortgage to any product you buy. Any business that sells a product seeks to make a profit. The price she asks for this product must therefore be higher than what it costs her. It’s the same for the lender: he makes a profit on the loan he gives you because you pay more interest (the price he asks you) than what it costs him to borrow this money (financing cost).
The cost of financing is what influences your mortgage rate the most. Other factors come into play, such as the lender’s operating costs and how much they need to cover the risk of you not repaying the loan, but the cost of financing remains the most important factor.
So what determines this cost?
The economic situation in Canada and abroad has had a great impact
Funds slow by banks come from depositors and investors in Canada and other countries. Thus, the cost of financing depends a lot on the interest rates offered here and abroad, which go up and down for various reasons.
Strong economic growth leads to increased demand for funds
In general, strong economic growth raises rates, while weak growth lowers them. Why? Because when the economy is strong, more companies seek funding from investors to finance their expansion. Mortgage lenders must therefore offer higher interest rates to investors to induce them to lend them funds rather than pass them on to another business. When the economy is sluggish, the opposite happens.
The global economy comes into play
Many Canadian banks borrow funds from other countries, particularly the United States. And because global financial markets are interconnected, interest rates in Canada are influenced by what is happening elsewhere. For example, when overseas rates fell in 2019, Canadian five-year fixed-rate mortgage rates also fell.
The Bank of Canada has an influence on interest rates
The Bank of Canada also influences interest rates, mainly by changing its key rate.
The main objective of the Bank of Canada is to keep inflation low.
When the economy is doing well, the Bank may raise this rate to prevent inflation from overshooting the target. Conversely, when the economy slows down, it must sometimes lower this rate to prevent inflation from falling below the target. Changes in the policy rate lead to similar movements in short-term interest rates, such as the prime rate used by banks to establish variable mortgage rates. These changes may also affect long-term rates, particularly if the new policy rate is expected to hold for some time.
In the past, high and variable inflation lowered the value of money. To compensate, investors demanded higher interest rates. The cost of financing was, therefore, higher for mortgage lenders. But since the Bank of Canada began inflation targeting in the 1990s, interest rates and inflation uncertainty have declined. As a result, the cost of financing is now much lower.
Mortgage rates and the pandemic
There are questions to be asked: as the COVID-19 pandemic spread, central banks – including the Bank of Canada – quickly cut interest rates to cushion the blow. But rates for new mortgages haven’t come down much, and some have even gone up. Why?
Keep in mind that it is the lender’s financing cost that largely determines the mortgage rate. The cost of funding jumped at the start of the pandemic due to investor jitters. Many simply wanted to hold on to their money given the great uncertainty that prevailed. As a result, financing that is normally easy for lenders to obtain has only become available in dribs and drabs. This is what drove up the cost of financing, even as the Bank of Canada’s key rate fell.
The Bank of Canada has taken many steps to help financial markets function better during the pandemic, as have the federal government and other public authorities. The aim is to ease tensions in funding markets so that lenders can continue to provide credit to households and businesses.
These measures include launching programs to ensure that lenders can access the financing they need. Thanks to these actions, the cost of financing has come down and some of the rates charged for new mortgages have started to come down.
Recall that rates on existing mortgages have not increased during the pandemic. These loans have either a fixed interest rate until their next renewal or a variable interest rate that has fallen at the same time as the Bank of Canada’s key rate.
The amount you pay also depends on you and the characteristics of your loan.
Your credit history and certain characteristics of the chosen mortgage determine the level of risk the lender takes. The greater the risk, the higher the rate.
Risk of non-repayment, or credit risk
The biggest risk for the lender is that you don’t repay the loan. A good credit score can alleviate this worry because it tells the lender that you are used to paying your debts well. You could thus obtain a lower interest rate than a borrower whose rating is lower than yours.
If your loan amount exceeds 80% of the value of the home, mortgage default insurance will be required. However, since this insurance protects the lender against the risk of default, you could obtain a better interest rate than if you opted for an uninsured loan by paying a higher down payment.
Interest rate risk
In Canada, most mortgages are renegotiated every five years, but their term can vary between six months and ten years. The more often you renegotiate, the more you expose yourself to the risk that the new rate will be different from the previous one. If you prefer a long-term fixed-rate, expect to pay for that peace of mind.
The lender may lose money if you pay off your mortgage early – this is called prepayment risk. Indeed, the lender will not be able to profit as much as expected from the funds obtained, especially if interest rates have fallen since the start of the loan. Therefore, an open mortgage, which allows full prepayment, is offered at a higher interest rate than a closed mortgage, which limits the amount you can prepay.
You’ll likely get a lower interest rate if you do your research and are willing to negotiate. Remember that you can choose your lender – large bank, smaller regional bank, credit union, or mortgage finance company – the choice is yours.