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How are mortgage rates calculated?

What is the prime rate in Canada and how does it move?

With recent talk of increasing interest rates, many individuals who have loans, lines of credit or variable mortgages tied to prime may be wondering what the prime rate is and how it will impact their finances over the next few years. Other than a few small changes to interest rates recently and in 2010, Canada hasn’t had to deal with the prime rate increasing markedly since 2005-2006. The long span of near-zero interest rates has many households in Canada near record debt levels—so Canadian borrowers are growing an increased interest (pun intended) on what the prime rate is going to do.

How the prime rate is set

To start with, the prime rate is a target lending rate in Canada that is used by banks to set interest rates for variable loans, lines of credit and mortgages. The rate is individually set by each bank, but when the prime rate is moved by one bank, other banks tend to follow and use the same rate within a day or two. The prime rate tends to be set based on what the Bank of Canada (BoC) sets their overnight target rate at. The BoC overnight target rate is the variable rate at which banks borrow money from the BoC.

Understanding the spread

As you can see from the blue line in the bottom portion of the chart, for many years now the spread between prime and the BoC target rate has been 1.75-2.25 per cent, but banks are free to deviate from that. As an example, the BoC may cut their target rate by 0.25 per cent, but banks only move prime down by 0.15 per cent. In this instance, banks can borrow from the BoC for 0.25 per cent less, but only drop the rate customers pay by 0.15 per cent. Banks keep a 0.1 per cent higher spread on their loans and increase their profitability. With interest rates far lower than they were 20 years ago, this seems to be the trend with banks increasing their spread over the BoC rate a few times since 2008.

How are mortgage rates calculated

Influences on the final rate

The final rate a customer sees in terms of prime plus or minus a certain per cent can be influenced by several factors such as how a bank’s loan and mortgage growth is doing, whether it’s secured and an individual's credit history. In a competitive environment when loan growth may be slowing, you are likely to see prime plus a smaller percentage, giving a better rate to the borrower and in some instances you may see prime minus a percentage if the loan is secured.

How the prime rate affects your mortgage

Given the popularity of fixed rate mortgages, it may be beneficial to touch on how these rates are set. They are primarily based off the three- to five-year Canada bond yields plus an additional percentage. Canada yields can be influenced by several factors: interest rate expectations from the BoC, inflation expectations, Canada’s economic health and even foreign economic conditions. It’s fairly safe to say that if the BoC is keen on raising interest rates, those increases will carry over to fixed rate mortgages as well—although it won’t be in near lockstep like it is with the prime rate. Additional percentage charged by the bank is determined by some of the same factors as the prime rate mentioned earlier, such as an individual borrowers creditworthiness and how competitive the mortgage environment is among banks to compete for business.

Rule of thumb for mortgages

Overall, the BoC is set on raising interest rates again and that will carry over to a higher prime rate. Traditionally, a variable rate was recommended. That has been the case since the early 1980s, but may not be the case going forward. Borrowers should be prepared for additional interest costs on their variable rate debt or when rolling a fixed rate mortgage over the next few years. If you plan to take out a loan, accommodate the additional future cost by leaving some breathing room and consider a fixed rate loan if you prefer more consistency.

If you’re still not sure what works best for you, we can help.​

ATB Financial

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