How Fixed Rates and Variable Rates Are Determined

Fixed mortgage rates in Canada are closely tied to Government of Canada bond yields, especially the 5-year bond yield. Here’s how and why:

Relationship Between Bond Yields and Fixed Mortgage Rates

• Fixed mortgage rates are primarily influenced by the 5-year Government of Canada bond yield.
• Lenders use the bond yield as a benchmark to set their rates, typically adding a spread of 1.2% – 2.5% to cover their costs and profit.
• When Bond Yields Go Up, Fixed mortgage rates go up.
• Why? Because the cost for banks to borrow or invest in longer-term funds increases.

They pass that cost on to consumers

• When Bond Yields Go Down, Fixed mortgage rates go down.
• Cheaper borrowing conditions allow lenders to offer more competitive fixed rates.

Why This Happens

Bond yields move based on:

• Inflation expectations (higher inflation → higher yields)
• Interest rate expectations (if the Bank of Canada is expected to raise rates, yields (rise)
• Investor sentiment (more demand for bonds → lower yields, less demand → higher yields)
• Global economic conditions

Example

• If the 5-year bond yield is 3.50%, and a bank adds a 1.5% spread, the 5-year fixed mortgage rate might be around 5.00%.
• If the bond yield drops to 3.00%, the rate could drop to 4.50%, assuming the same spread.

Key Takeaways

• Fixed mortgage rates move in tandem with Government of Canada bond yields.
• Keep an eye on the 5-year bond yield if you’re shopping for a 5-year fixed mortgage.
• Unlike variable rates (which track the Bank of Canada’s policy rate), fixed rates are influenced by the bond market.

Variable Rates

In Canada, variable mortgage rates are primarily determined by the Bank of Canada’s overnight rate, but more specifically, they are tied to a lender’s prime rate, which moves in response to changes in the central bank’s policy rate.

How Variable Rates Are Determined

1. Bank of Canada Overnight Rate

• This is the benchmark interest rate set by the Bank of Canada (BoC) and it directly influences the prime rate used by financial institutions.
• The BoC typically adjusts this rate to control inflation and manage economic growth.

2. Lender’s Prime Rate

• Banks and other lenders set their prime rate based on the BoC’s overnight rate.
• When the BoC raises the overnight rate, lenders usually increase their prime rate by the same amount (and vice versa).
  • Example: If the BoC increases the overnight rate by 0.25%, the prime rate usually increases by 0.25% too.
• Your Mortgage Rate = Prime Rate ± Discount or Premium

Your actual variable mortgage rate is usually expressed as:

Variable Rate = Prime Rate – Discount

• Example: If a lender’s prime rate is 7.20% and your mortgage is Prime – 1.00%, your rate is 6.20%.
• Sometimes, lenders offer Prime + X%, this is more common with Home Equity Lines of Credit (HELOC) and Rental properties.

What Causes Variable Rates to Change?

• Changes in the BoC’s overnight rate (usually announced 8 times per year).
• Economic indicators like inflation, employment, GDP growth, and global events that may influence the BoC’s decisions.

Summary Table

Component                      Role in Determining Variable Rate

Bank of Canada Rate        Primary influence on prime rate

Lender’s Prime Rate          Baseline rate lenders use

Discount/Premium            Negotiated portion of mortgage rate

Key Takeaways

• Variable rates move in lockstep with the Bank of Canada’s overnight rate, through the prime rate.
• If the BoC raises rates, your monthly interest cost goes up.
• Your payment may or may not change immediately (depends on whether your variable mortgage is adjustable-rate or fixed-payment variable).