When considering a mortgage, one of the critical decisions homebuyers face is choosing between a fixed-rate and a variable-rate mortgage. Both options have distinct advantages and risks, influenced significantly by changes in bond rates and the Bank of Canada rate. Understanding how these economic factors affect mortgage rates can help borrowers make informed decisions that align with their financial goals and risk tolerance.

The Bank of Canada Rate and Its Influence on Variable Mortgage Rates

The Bank of Canada (BoC) rate, also known as the overnight rate or the key interest rate, is the interest rate at which major financial institutions borrow and lend one-day (overnight) funds among themselves. This rate is a primary tool for the BoC to influence monetary policy, aiming to control inflation and stabilize the economy.

Changes in the BoC rate have a direct and immediate impact on variable mortgage rates. Here’s how it works:

1. Direct Correlation: Variable-rate mortgages are typically tied to the prime rate, which is influenced by the BoC rate. When the BoC raises or lowers its rate, lenders usually adjust their prime rates accordingly, almost in real-time.
2. Immediate Impact: For borrowers with variable-rate mortgages, any change in the BoC rate will result in an immediate adjustment to their mortgage interest rate. If the BoC rate increases, the interest portion of their mortgage payment will rise, increasing overall monthly payments. Conversely, a decrease in the BoC rate will lower the interest rate on their mortgage, reducing monthly payments.
3. Predictability and Strategy: Borrowers with variable-rate mortgages need to be attuned to economic indicators and BoC announcements. A rising rate environment may lead them to consider switching to a fixed-rate mortgage to lock in a stable rate, while a declining rate environment could be beneficial for maintaining a variable rate to take advantage of lower interest costs.

Bond Rates and Their Effect on Fixed Mortgage Rates

Fixed-rate mortgages are influenced more by bond rates, specifically government bond yields. Here’s how bond rates affect fixed mortgage rates:

1. Indirect Relationship: Fixed mortgage rates are closely tied to the yields of government bonds, particularly the 5-year bond yield in Canada. When bond yields rise, fixed mortgage rates tend to increase, and when bond yields fall, fixed mortgage rates generally decrease. This relationship exists because lenders use bond yields as a benchmark for setting their fixed mortgage rates, ensuring they maintain a spread that covers their costs and desired profit margins.
2. Market Sentiment and Economic Outlook: Bond yields are influenced by various factors, including inflation expectations, economic growth, and investor sentiment. For instance, if investors anticipate higher inflation, they may demand higher yields on bonds to compensate for the reduced purchasing power of future interest payments. Consequently, mortgage lenders will raise fixed rates to maintain their profit margins.
3. Lagged Effect: Changes in bond yields can affect fixed mortgage rates, but not as immediately as changes in the BoC rate affect variable rates. There’s often a lag as lenders adjust their offerings based on sustained trends in bond yields rather than short-term fluctuations.

Comparing the Two: Variable vs. Fixed Mortgage Rates

Understanding how bond rates and the BoC rate influence mortgage rates can guide borrowers in choosing between variable and fixed mortgages. Here’s a comparison of the two in light of these economic factors:

1. Variable-Rate Mortgages:
   • Flexibility and Savings Potential: In a declining or stable BoC rate environment, variable-rate mortgages can offer significant savings compared to fixed-rate mortgages, as the interest rates will be lower.
   • Risk and Uncertainty: The primary risk is rate volatility. If the BoC rate increases, monthly mortgage payments can rise, potentially straining a borrower’s budget.
2. Fixed-Rate Mortgages:
   • Stability and Predictability: Fixed-rate mortgages provide stability in monthly payments, making budgeting easier and protecting borrowers from interest rate hikes. This is particularly appealing in a rising bond yield environment, where fixed rates are expected to climb.
   • Potential for Higher Costs: Borrowers might end up paying more if they lock in a fixed rate during a period of high bond yields, especially if rates fall subsequently.

Conclusion

The decision between a fixed-rate and a variable-rate mortgage hinges on understanding how bond rates and the Bank of Canada rate influence these options. Variable rates offer potential savings and flexibility in a low or stable rate environment, but come with the risk of increased payments if rates rise. Fixed rates provide predictability and protection against rate hikes, albeit possibly at a higher initial cost.

Borrowers should consider their financial situation, risk tolerance, and economic outlook when choosing a mortgage type. Consulting with mortgage professionals can provide valuable insights tailored to individual circumstances, ensuring a well-informed and strategic decision in the complex landscape of mortgage rates.