The age-old rate debate. In this blog post, we talk a bit more about whether variable rate mortgages are better than fixed.
Over the past few years, the mortgage rates in Canada have been at a record low. We’ve seen the overnight rate start to increase and decrease to a neutral rate of 2.25% to 2.5%. There are many different factors that influence the overnight rate and mortgage rates. These can include unemployment, managing inflation, and stimulation in the economy. Depending on what kind of mortgage it is, whether it’s a variable rate or it’s a fixed rate, will determine what factors influence it to change.
Variable Rate Mortgages
Variable rate mortgages are influenced by commercial banks’ prime rates. The prime rates are affected by the Bank of Canada’s overnight rate, which is currently at 1.75%. The Bank of Canada will lower the overnight rate when it wants to stimulate the economy. Alternatively, they will increase it when they want to decrease inflation. Large banks will use the overnight rate as a benchmark when they are setting their interest rates. Therefore, when we see a change in the overnight rate, we will almost immediately see an equivalent change in variable rate mortgages.
When large banks promote their variable rates, they put prime +/- N%. Suppose that the current overnight rate is 1.75% and the commercial banks’ prime rate is at 3.95%. The variable rate could be quoted as prime -1.10%, which means the variable is 2.85%. If the Bank of Canada were to increase the overnight rate from 1.75% to 2%, the major banks would follow by increasing their prime rate by the same amount. So, the prime rate would increase to 4.20% and the variable rate would also change to 4.20%-1.10% = 3.10%.
Fixed Rate Mortgages
While fixed rate mortgages are also set by the Bank of Canada, they are determined by the price of Canada Savings Bonds. A bond yield is the return an investor will receive by holding a bond to maturity. Government issued bonds are some of the least risky assets since they’re guaranteed by the Canadian government. The supply and demand game in the bond market will determine their price and in turn will determine their yield. The yield can be conveyed as the minimum rate of return that’s required by investors before they make a capital investment for a certain period.
The price of bonds has a negative relationship with bond yields. This means that when bond prices increase, bond yields decrease. Unlike the negative relationship between bonds and bond yields, the relationship between fixed rates and bond yields is positive. As bond yields increase, fixed rates will also increase, and when bond yields decrease, fixed rates will decrease with them.
When the stock market is doing well, investors are anticipated to make a higher return on investing in equities, like the stock market, than investing in bonds. This will mean that the demand for bonds decreases and the price of bonds decreases. What does that mean for bond yields and fixed rates? With the prices of bonds decreasing, bond yields will increase, and fixed rates will also likely increase. For instance, if the Government of Canada’s 5-year bond yield increase, generally the 5-year fixed rate mortgage will increase as well.
If you’re interested in learning more about how mortgage rates are determined and how certain factors can influence your mortgage, get in touch with us here.