Buying a home is an exciting time. However, navigating the mortgage process can be overwhelming. One of the most important decisions you'll need to make is choosing a fixed or variable mortgage rate, the percentage of interest you'll pay for your mortgage. But how do lenders decide on the rate they'll give you?
In Canada, unlike the fixed price of a product, mortgage rates are not set in stone. A combination of national and individual factors influences the rate you are offered. Understanding these factors will help you decide your mortgage strategy and save you a lot of money in the long run.
The Bank of Canada Sets the Stage
The Bank of Canada plays a crucial role in managing the Canadian economy. One key instrument they utilize is the policy rate, also referred to as the overnight lending rate. This rate determines the cost of overnight lending between major banks.
When the Bank of Canada raises the policy rate, it becomes more expensive for banks to borrow money. Consequently, banks may increase the prime rate offered to their most creditworthy customers. This hike in the prime rate often leads to higher mortgage rates across the board.
Bonds Silently Influence All Rates
Bonds are like an “I owe you" that governments and companies issue. When you buy a bond, you essentially lend the issuer money in exchange for interest payments. The interest rate on a bond is known as the bond yield.
Government bond yields with terms similar to fixed mortgages (e.g., 5-year bond yield for a 5-year fixed mortgage) can impact mortgage rates. This is due to banks and the government competing for investor funds. If investors seek higher returns on government bonds, banks might need to increase their mortgage rates to remain competitive and draw in investors.
US treasury yields are influenced by various economic factors, such as inflation, job reports, GDP, and national debt to GDP, which also impact Canadian bond yields. When US treasury yields go up, Canadian bond yields usually follow suit. On the other hand, Canadian bond yields tend to drop when US treasury yields decrease.
Rates Ride Inflation
Inflation occurs when the prices of goods and services rise due to many factors, such as supply shortages, increasing demand, or rising labour costs. This decreases the purchasing power of money, making it more expensive to purchase the same goods or services. To control inflation, the Bank of Canada may raise the policy rate and make borrowing more expensive, including mortgage rates.
When inflation begins to reduce slightly, this is referred to as disinflation. This means that prices for goods and services still increase but at a much slower pace. Tighter monetary policy measures like a higher policy rate can lead to disinflation. This is where the Canadian economy is today as the Bank of Canada implements cuts to the policy rate, aiming for a soft landing.
Deflation occurs when the prices of goods and services fall, resulting in an inflation rate below 0. This last occurred in the Canadian economy in April and May 2020, when CPI was -0.2% and -0.4%. When this happens, the Bank may lower the nation’s benchmark policy rate to prevent the economy from experiencing higher unemployment rates or a possible recession.
Personal Factors That Influence Your Mortgage Rate
Mortgage rates are determined based on the Bank of Canada policy rate, which directly impacts all variable mortgage rates and your lender’s prime rate and indirectly impacts all fixed mortgage rates through bond yields. However, other factors can influence how your mortgage rate is priced, resulting in a premium added to the policy rate or bond yield to offset the bank's funding costs.
Various factors impact mortgage rates, such as credit score, income, downpayment, and loan purpose. The loan-to-value (LTV) ratio also plays a role in determining rates, as it is influenced by the risks linked to the mortgage, property, and you as the borrower.
Mortgage Term
The mortgage term refers to the duration of your mortgage agreement. Fixed mortgage terms typically include 6 months, 1 year to 5 years, 7 years and 10 years. Variable mortgage terms are typically limited to 6 months, 1 year, 3 years, and 5 years. Lenders consider the term primarily, among other factors, when determining mortgage rates. In 2024, 3-year fixed, 5-year fixed and 5-year variable remain popular options to obtain low mortgage rates; however, your best option will depend on your financial circumstances.
Mortgage Type
Different types of mortgages include adjustable, variable, fixed, open, closed, standard charge, or revolving home equity line of credit (HELOC) under a collateral charge. The mortgage type you choose will impact the interest rate.
Open mortgages typically have higher interest rates than closed ones because they provide more flexibility in paying off your mortgage before its maturity without incurring penalties.
There are 2 main types of variable mortgages: variable-rate mortgage (VRM) and an adjustable-rate mortgage (ARM). With an ARM, the mortgage payment changes according to your lender's prime rate fluctuations. With a VRM, the mortgage payment remains the same, but the distribution between principal and interest shifts, impacting the amortization schedule. Both types of variable mortgages come with various risks and benefits.
Variable rates are determined by the lender's prime rate, based on the Bank of Canada policy rate plus a spread. Fixed rates are determined by bond yields of corresponding maturities, such as 5-year fixed rates following 5-year bond yields, along with a spread. While historically, variable mortgages have had lower interest rates than fixed rates, this has shifted in recent years.
Lenders use standard and collateral charges to protect their investment when providing you with a mortgage. A standard charge is a single registration for your home loan. A collateral charge is a registration covering the entire value of your property, enabling you to access additional funds through multiple mortgages under one registration. Additionally, HELOCs (Home Equity Line of Credit) are typically established using the equity in your property within a collateral charge, serving as a flexible line of credit for borrowing and repaying as required.
Downpayment
Your downpayment will determine the proportion of your loan amount to the property's value, also known as your loan-to-value (LTV) ratio and whether you must purchase mortgage default insurance. Mortgages that are insured or can be insured (also known as insurable) generally come with lower interest rates because mortgage default insurance decreases the risk for the lender if you cannot make your mortgage payments. Uninsured mortgages typically have higher interest rates to compensate for the risk to the lender associated with these mortgages.
A larger downpayment on a home purchase impacts the money you must borrow from the lender. A higher down payment means borrowing less money, reducing the lender's risk and potentially leading to a lower interest rate for you.
Qualifying Ratios
Lenders assess your ability to afford a mortgage by analyzing your Gross Debt Service (GDS) and Total Debt Service (TDS) ratios. GDS compares your housing costs to your gross income, while TDS considers all your debts. For CMHC-insured mortgages, the standard ratios are 39% for GDS and 44% for TDS.
To determine your qualifying mortgage payment, a stress test is conducted using the higher of your contract rate plus 2% or the minimum qualifying rate, which is currently 5.25%. The lower your qualifying ratios, the less risky you appear to a lender, and you’re likely to receive more competitive rates.
Property Use
As a first-time homebuyer (FTHB) or move-up buyer who decides to make the property your primary residence, you may qualify for lower interest rates than a rental property. Purchasing a primary residence property that includes a separate legal rental suite will be classified as an owner-occupied rental. These properties still allow you to benefit from the same favourable rates as a primary residence.
Transaction Type
Refinancing mortgages are considered riskier than purchases and renewals, as they cannot be default-insured. Due to the increased risk of borrowers defaulting on their payments, lenders charge higher rates for refinancing or uninsurable properties, such as those valued over $1 million.
When a mortgage is converted from a variable to a fixed rate, it is essentially a type of early renewal. Lenders typically offer non-discounted rates when transitioning from a variable or adjustable rate to a fixed mortgage rate.
Amortization
When paying off your mortgage, the amortization you choose can significantly impact the amount of interest you pay. Opting for a shorter amortization period can save you money in interest, but it will also mean higher monthly payments. Selecting an extended amortization period will result in lower monthly payments, but you will ultimately pay more interest over the life of the loan.
Credit Score
A good credit score is crucial to securing the lowest prime lending mortgage rate. Your credit score reflects your history of managing debt. A high credit score signals to lenders that you are reliable, potentially resulting in a lower interest rate. A low credit score suggests a higher likelihood of payment defaults, prompting lenders to impose a higher interest rate to mitigate risk.
Borrowers with excellent credit scores typically receive the most favourable rates and can often access the lowest prime lending rates. Individuals with poor credit may need to explore other options from alternative lenders that offer higher interest rates.
Proof of Income
Proof of consistent income is essential to secure the most favourable mortgage rates. You can verify this by submitting paystubs, employment letters, or T4s if employed by someone else.
When self-employed or a business owner, you must present your Business Registration or Articles of Incorporation, Notice of Assessments (NOAs) T1 General, and 3 months of bank statements for your corporate, business or personal accounts.
Why Shopping for a Mortgage Can Help Lower Your Rate
When searching for the best mortgage rates in Ontario, Quebec, Alberta, or anywhere else in Canada, rate comparison websites can simplify your search by allowing you to compare different mortgage options and find the most suitable one for your needs.
Instead of visiting multiple lenders or scouring numerous websites, you can use these tools to compare your options easily. With CompareMortgages and MonMeilleurTaux, you can assess each mortgage offer, enabling you to make decisions more quickly - saving you time and effort when shopping for a mortgage.
This can assist you in finding the best mortgage for your situation, whether you're purchasing a home or renegotiating your mortgage rates in Montreal, Calgary, or Toronto.
Advice Matters
Understanding the factors influencing mortgage rates is crucial in finding the best mortgage for your financial needs and circumstances. The mortgage market can be complex, so it's advisable to seek assistance from a mortgage professional.
With the help of a mortgage expert, you can evaluate your financial situation, compare rates from various lenders, and select your most suitable mortgage option. By gaining a deeper understanding of mortgage rates and receiving expert advice, you can confidently move forward in your journey toward homeownership.
Discussing your financial situation and mortgage needs with a mortgage expert is highly recommended to ensure you make the best decision for making yourself mortgage-free faster. They can provide valuable insights and help you complete a cost-savings analysis, allowing you to make a well-informed choice that aligns with your unique circumstances. Reach out to one of nesto's mortgage experts, who can assist you in determining the best mortgage strategy for you.