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How Mortgage Rates Are Set

It’s easy to say that mortgage rates are “affected by economic factors,” or more specifically “bond yields” or “the Bank of Canada”, but are you really getting an understanding with those answers?

First off, there are two types of mortgage rates: variable and fixed. Both are driven by similar economic factors, but they are affected by different factors too.

Variable mortgage rates vary and fluctuate with what is known as the prime lending rate. This rate is set by the Bank of Canada based on its interpretation of the state of the economy and inflation targets. When the prime rate goes up, variable mortgage rates go up, and vice versa. This is why variable mortgage holders take on a bit more risk over the term of their mortgage and should watch the Bank of Canada announcements.

Fixed mortgage rates, where the interest rate is fixed over the course of the mortgage term, are a little more complicated – they shadow Government of Canada bond yields of the same term. In fact, there is a very positive correlation between the two.

Bond yields are determined by the price of bonds and have an inverse relationship with them. For example, if a five-year bond falls in price, this means the yield (return for investors) goes up. Similarly, if the price increases, the yield falls.

Bonds are like safe havens for investors: they offer guaranteed repayment on funds the investor loans to the issuer (in this case, the government) after the term of the bond has passed (plus a set rate of interest known as the coupon). When the economy is booming and the market is good, big returns can be had by investing in alternatives, and bond prices tend to fall so bond yields rise. When the market is bad, demand for safe money increases, so bond prices rise and yields fall.

Meanwhile, mortgages are funded through capital issues and often the bond market. The interest rate on a mortgage depends on the yield (return) the bank provides bond investors. When investors demand a higher yield, mortgages must also be issued at a higher fixed interest rate that is in line with the cost to the bank. The cost of borrowing for the bank to fund mortgages is essentially the percentage yield paid to investors of the bond.

The second factor influencing fixed mortgage rates will be the spread required by financial institutions, on top of the bond yields. Three main components influence this spread: the cost of trades and transactions of the loan, a risk premium (in the case of default payment) and finally the profit margin that the financial institution desires.

We could summarize that for the duration of a loan, fixed mortgage rates are determined on the following basis: cost of capital + administration costs and/or mortgage negotiations + risk premium (in the risk of the borrower defaulting on the mortgage) + the bank’s desired profit = cost of the mortgage for the borrower.

In short, if you are trying to predict where fixed mortgage rates are headed, look to the bond market.