Mortgage rates are at the heart of every home purchase decision, yet they often confuse borrowers. Understanding how the Bank of Canada (BoC) impacts these rates and how fixed and variable mortgages differ can help you make smarter financial choices. Here's a comprehensive look at the mechanics behind Canadian mortgage rates.

The Bank of Canada: The Core of the System

The Bank of Canada acts as the backbone of our financial system. It doesn’t just create the money supply—it also sets the Overnight Lending Rate (or Key Interest Rate), which is the rate it charges banks to borrow money. This rate significantly influences how much it costs Canadians to borrow funds for mortgages, credit cards, and lines of credit.

The BoC uses the overnight rate as a tool to manage inflation:

• When inflation is high, the BoC increases this rate. Borrowing becomes more expensive, discouraging people and businesses from taking on new debt. This slows down spending and eases inflationary pressures.
• When inflation is low, the BoC lowers the rate to encourage borrowing and stimulate economic activity. This helps push inflation back to healthy levels.

However, the impact of these changes isn’t immediate. Rate adjustments typically take 6 to 8 months to influence inflation. This means today’s inflation is a result of policy decisions made months ago. The Bank of Canada constantly forecasts economic trends, relying on data and analysis from top economists to make rate decisions.

Understanding the Prime Rate

While the BoC influences borrowing costs, the prime rate—the benchmark for many lending products—is actually set by individual lenders. The prime rate is directly tied to the BoC’s overnight rate, but each bank or lender determines its own version of prime, which may vary slightly.

How Prime Affects Borrowers:
Prime rate changes influence:

• Variable-rate mortgages
• Lines of credit
• Certain savings account rates

For example:

• A variable-rate mortgage might be quoted as Prime - 0.85%, meaning your interest rate will always be 0.85% lower than the lender’s prime rate.
• A line of credit might have a rate of Prime + 2%, meaning it’s 2% higher than the prime rate.

When the BoC announces a rate hike or cut, lenders may take days—or even weeks—to adjust their prime rates. The timing of changes also varies depending on the lender’s internal policies. In some cases, the adjustment aligns with your next payment cycle.

Variable-Rate Mortgages: Flexible but Unpredictable

Variable-rate mortgages are directly tied to the lender’s prime rate, meaning your interest rate can increase or decrease based on changes in the prime rate. There are two main types:

1. Adjustable Payment Plans: Your monthly payment fluctuates as the prime rate changes.
2. Fixed Payment Plans: Your monthly payment stays the same, but the proportion applied to interest versus principal changes.

Variable-rate mortgages can offer savings during periods of low interest rates. However, they come with the risk of higher payments if rates rise. Borrowers need to be comfortable with the possibility of changing costs.

Fixed-Rate Mortgages: Stability and Predictability

Fixed rates, by contrast, are influenced by the Canadian bond market, not the Bank of Canada. Specifically, the 5-year government bond yield is a key driver of 5-year fixed mortgage rates. When bond yields rise, fixed rates increase; when they fall, fixed rates decrease.

What Influences Bond Yields?
The bond market reacts to a wide range of economic factors, including:

• Inflation and employment data
• Global market conditions
• Political events (e.g., elections, geopolitical tensions)

For example, if inflation reports show a decline, bond yields may drop in anticipation of reduced economic risk. This could lead to a reduction in fixed mortgage rates. However, this process is independent of BoC rate changes, which is a common source of confusion for borrowers.

Fixed vs. Variable: Making the Right Choice

Choosing between fixed and variable rates boils down to your personal financial situation, risk tolerance, and future plans.

• Fixed rates provide security and predictability, ideal for those who prefer consistent monthly payments.
• Variable rates offer potential savings when rates are low but require comfort with potential payment fluctuations.

It’s important to note that interest rates are just one piece of the puzzle. Factors like prepayment penalties, mortgage flexibility, and term lengths should also play a role in your decision-making process.

Why Rate Timing Doesn’t Have to Be Perfect

Many borrowers stress over timing their mortgage decision to secure the "best" rate. However, predicting where rates will go is nearly impossible. Over the life of a mortgage, rates will inevitably rise and fall. The goal is to make the best decision based on today’s information, understanding that no one can predict the future.

For instance, during the COVID-19 pandemic, borrowers in 2019 locked in fixed rates at around 3.29%. By 2020, rates had fallen to 1.84%, leaving many wishing they had chosen a variable rate. Conversely, in 2022, variable rates climbed to 6%, and fixed-rate borrowers felt relief. These fluctuations highlight the importance of taking a long-term perspective.

Final Thoughts

Your mortgage is one of the most significant financial commitments you’ll make. Whether you choose a fixed or variable rate, it’s essential to feel comfortable with your decision. Work with a trusted mortgage broker to evaluate your needs and find the best product for your unique situation.

Remember, the “best” rate isn’t just about numbers—it’s about what works for you and your financial goals.

If you have questions about this topic or any other mortgage-related inquiries, feel free to reach out to me at sunny@TheMortgageStation.ca or give me a call at 705.220.0334. I’d be happy to help guide you through the process and answer any concerns you have about choosing the right mortgage option for your needs!