How are mortgage rates are determined?

Want to buy a home? Chances are you’re going to need a mortgage (or you’re going to get a mortgage even if you don’t need one simply because you understand the power of leverage and the compounding impact of diversifying your wealth).

For most, though, qualifying for a mortgage is the only way buying a home becomes an affordable reality. It’s true, then, that the higher mortgage rates climb, the less affordable housing in Canada becomes. But what determines when mortgage rates rise? What factors will prompt a rise and fall of mortgage rates?

To understand what is occurs in the mortgage market, we need to understand how this market interacts with the overall economy and, in particular, with the capital market.

Influence of the capital market

The capital market isn’t a trading platform or store. It refers to the transfer of funds from those who have excess — savers or investors — to those in need (borrowers). In essence, the capital market is the relationship between supply and demand for money in the marketplace.

One of the most significant factors of the supply and demand for funds is the interest rate that governs this process. The interest rate dictates how much a saver (or investor) can expect to earn when they lend out their money; the interest rate also dictates how much it will cost borrowers to use that loaned money. In economic terms, the interest rate is the ‘price’ of borrowed money.

How the transfer of saved money to borrowed money works

In the past, banks would lend money, in the form of mortgages, from the money deposited by savers. Over time, the competition to loan out money and to acquire those saved dollars became so great that banks and credit unions had to find alternative sources of funding. One way was for the bank to borrow money at one rate and then charge their loan client a higher rate. To borrow, banks had to go into the debt capital market — the market where large institutional money managers needed to find investments that offered a decent return but with a high degree of capital preservation. (They wanted near risk-free investments and banks are a pretty good bet for this type of investment.) Don’t be fooled, banks continue to seek out no or low-interest loans — typically in the form of savings from individuals.

As with all loans, the lower the risk the lower the rate of return. Since banks are regulated and, as such, required to keep a certain amount of reserves to cover their obligations, they are considered low risk. Individual borrowers, on the other hand, are not limited by these regulations and have far more flexibility to do what they want with their assets. This adds an element of risk. Since risk costs, this means individual borrowers must pay more to borrow the same money. While a bank may borrow at a rate of 1.5% from the Bank of Canada, that same bank will charge a very well-positioned mortgage borrower 3.85% — more to the higher risk clients.

In the financial markets, government-backed financial instruments, such as bonds, serve as the gold standard for a risk-free investment. Most agree that governments have almost zero default risk (partly because they have an electoral responsibility and partly because they have the ultimate option to raise more money by increasing our taxes or control money supply (among many other variables).

As such, a government bond represents a promise by the government to pay the interest stated and to repay the original capital at the stated maturity date.

The bank’s role in the capital market

As an almost risk-free investment, savers like the security of government bonds (particularly federal government bonds). But there are ways to convince savers to abandon their ultra-safe strategy and invest elsewhere. One way is to offer a better return. For instance, if five-year government bonds currently pay 1.5%, banks and mortgage lenders would need to offer more than that to entice those investing in debt capital (otherwise known as bonds) to invest their money in mortgage debt. (More risk requires a bigger reward.)

This means the single largest factor to influence fixed-rate mortgage rates (and, to a degree, variable mortgage rates) is the relative return a saver can expect by investing in a government bond. This rate will either entice money to settle in bonds or will prompt these savers to look elsewhere in the capital market to find a better return. In order to encourage those who are open to investing in debt capital (because that’s what a bond is: a promise to pay back your invested loan, plus interest) to invest in mortgages there must be some kind of premium. The interest earned on this investment must be higher than the interest earned on a bond.

But why would a bank bother to try and get more saved money? Or put another way: Why would a bank offer a better rate of return to savers if that rate of return is higher than the interest charged at the Bank of Canada, where many banks go for capital. Because the Bank of Canada is not a lender, it’s a cash-flow supplier. Our national bank isn’t in the business of investing, it’s in the business of keeping capital flowing. The free-flow of capital means the economy can function well and that means profit and that means taxes and economic growth. So, if the banks can’t rely on borrowing from the Bank of Canada in order to have funds for their mortgage and loan clients, then the banks need to raise funds another way. Of course, the optimal method is to find no or low-interest money — money in savings accounts that offer meagre interest rates or money in “high-interest” TFSAs (that rarely climb above 3% in annualized returns). Quite often, however, the demand for loans is much greater than the supply of no or low-interest money, so the bank must go out and attract more money and then loan it out at a higher rate.

Since the banks must pay to use the money, they pass this cost on to their borrowing clients. Wait, this is where it gets interesting. This is when the banks add a little bit more, in order to earn a profit. The difference in what it costs a bank to borrow and what it earns is known as the spread. The spread effectively determines the premium charged for investing in mortgages instead of government bonds. To earn a profit, the bank needs to create a large enough spread that it covers all extra costs plus earn a profit. What you will find is that these spreads generally remain pretty constant  — a good thing since they have a fiduciary responsibility to their shareholders, which is just about anyone who holds a broad-based mutual fund or ETF.

What does that mean for you, the saver or borrower? It means you need to pay attention to bond rates and to the Bank of Canada’s overnight rate (the rate banks pay for their short-term loans). By tracking the day-to-day movement of these rates in the financial markets you will have much better success at predicting which way mortgage rates will move.

About the Author

Calum Ross has funded over $2.5 billion in (6,500) mortgages since 2000, helping to create more than $1.8 billion of incremental net worth for his clients. He is the Amazon and Globe & Mail bestselling author of The Real Estate Retirement Plan with plans to launch an updated version of the book in 2019. Calum is a leading authority on personal finance and investing in real estate and has spoken on stages across Canada and the U.S. He is an alumnus of Harvard Business School and holds an MBA in finance from the Schulich School of Business. He lives in Toronto.

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