Mortgage Rates: How Do They Really Work?

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Buying a home is probably the biggest purchase you’ll ever make. Like most people, it’s unlikely you’ll pay in cash—you’ll borrow most of the money through a mortgage. Over the life of that mortgage, you’ll pay a lot in interest.

Small changes in this interest can make a big difference in how much you’ll pay over that mortgage life; so it’s important that you understand what determines the interest rate on your mortgage, even if you already own a home.

Some factors are part of the cost of all mortgages

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).

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. What determines it?

The Canadian economy matters a lot (and the rest of the world a bit as well!)

The money that banks lend out comes from depositors and investors, both here in Canada and in other countries. So, funding cost is largely driven by the interest rates in these places. And these rates move up and down for several reasons.

Strong economic growth means more demand for money

In general, strong economic growth tends to lead to higher interest rates, while weak growth leads to low interest rates. Why? When the economy is strong, more companies want to borrow from investors to expand their business. So, a mortgage provider has to pay a higher interest rate to get investors to lend to it. And when the economy is weak, the reverse is true.

The global economy matters

Many Canadian banks borrow money in other countries, particularly the United States. And keep in mind that the world’s financial markets are interconnected. Interest rates in Canada respond to what happens elsewhere. For example, foreign interest rates fell during 2019. Interest rates for Canadian five-year fixed mortgages dropped in response.

The Bank of Canada influences interest rates

The Bank of Canada also affects interest rates, mainly through changes in our policy interest rate.

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 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.

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.

It looked like a puzzle: As the COVID-19 pandemic spread, central banks—including the Bank of Canada—quickly cut interest rates to cushion the blow. But rates on new mortgages didn’t decline much, and some actually went up. Why?

Remember that your lender’s funding cost determines most of the mortgage rate. The cost of funding jumped in the early days of the pandemic as investors became nervous. Many simply wanted to hold on to their cash given how uncertain everything was. So, the funding that is normally easy for lenders to get slowed to a trickle. This drove up the funding cost, even as the Bank of Canada’s policy interest rate fell.

The Bank of Canada has taken all sorts of measures to help financial markets work better during the pandemic, along with the federal government and other public authorities. The goal is to ease strains in funding markets, so lenders can keep supplying credit to households and businesses.

These steps include launching programs to make sure lenders can access the funding they need. As a result of these actions, funding costs fell and some mortgage rates on new loans started to decline.

Keep in mind: existing mortgages didn’t become more expensive during the pandemic. They either have an interest rate that is fixed until its next renewal, or a variable interest rate that declined along with the Bank of Canada policy rate.

You and the characteristics of your mortgage also affect how much you pay

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.

Repayment or 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.

If your mortgage is worth more than 80% 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.

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 than 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.

Prepayment risk

The lender risks losing money if you repay your mortgage early—known as prepayment risk. Why? 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.

It’s important to shop around!

You can easily find a lower interest rate if you do your homework and are willing to negotiate. Don’t forget that lender options are aplenty; large & small banks; regional banks; credit unions; or mortgage financing companies.