Understanding Interest Rates

Buying a home is usually the biggest financial transaction most of us will make in our life. Therefore shouldn’t you understand the financing process and what causes interest rates to move up and down? I am going to attempt to shed a little light on the subject and hopefully after you spend the next couple of minutes reading this post you will be much better informed.

Like most people who own a property or are thinking of purchasing a property, you have been watching interest rates closely over the last few months. You have also probably noticed that the governments prime rate has been falling steadily in Canada. So how does this translate into the rate you are going to pay for your mortgage? It turns out the correlation is not as direct as you might think.

The first point I want to stress is the banks do not finance your mortgage by borrowing money from the government. Therefore the government’s prime lending rate does not have a direct impact on your mortgage. Mortgages (variable and fixed) are financed through the banks’ deposits. This is where the banks get all of the money for their loans. They pay you a very small interest payment, but lend the money out at a higher interest rate. The difference between the two amounts is their profit. The banks then take thousands of these mortgages and package them up into investments called mortgage backed securities. You can take a look at a previous post to watch a small video on how these securities work. You have probably heard of these mortgage backed securities as the financial instruments that helped bring down the global economy. Keep in mind, in Canada these investments are fairly safe due to our stringent lending practices. However, several other countries have had quite a bit of trouble with these securities because the mortgages that made them up were basically junk.

So you are probably still wondering how the interest rates of mortgages are set. Well, when the bank is trying to figure out how much interest to charge on a mortgage they look to the bond market to see what yield the corresponding bond is paying. For example, let’s assume the bank wants to price their 5 year fixed mortgage. They would check bond prices to see what a typical 5 year bond is yielding (paying in interest). Let’s assume the Government of Canada 5 year Bond is paying 3.25% in interest. The bank would then use the 3.25% as a base and then add on a premium to cover all of their costs of issuing the mortgage (pay the broker, back office staff, administrative costs…etc)….let’s assume another 2%. So the bank is going to offer you a mortgage of atleast 5.25% (3.25 + 2.00).

The prime rate for variable mortgages works the same way. The banks use the governments prime lending rate as a benchmark and then add a premium to the rate to cover their costs. The banks are under no obligation to drop their prime rates when the government drops its prime rate, however most of the time they will. You also need to check your mortgage to see when your rate resets. Some lenders will reset your variable rate as soon as the bank’s prime rate changes. Some will do it once a month  and some will only do it once a quarter.

I hope this has helped add some clarity on how mortgage rates are set and why you can’t expect fixed mortgage rates (or variable for that matter) to drop in tandem with the government’s lending rate. As a mortgage broker it is my job to monitor interest rates for my clients. I watch bond rates daily in an effort to predict the direction of  rates so I can help my clients pay less interest, and pay off their mortgage quicker!

If you have any questions please contact me. As well, if you found this post helpful feel free to share it by clicking on the “Share it” button below.

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