The Basis of the Mortgage Rates (How They Work)

As we all know, real estate financing plays an integral role in the affordability of real estate to most Canadians. In fact, every 1% increase in residential mortgage rates literally ends the dream of home ownership for thousands of Canadians. When these rates play such an integral role in the availability of housing for Canadians, how is it that so many people have so little understanding of how these rates and mortgage pricing models are arrived at?

The mortgage market is definitely a segment unto itself in the financial marketplace. Still, to understand what is occurring in the mortgage market, one must understand how it interacts with the overall market for funds, commonly referred to as the capital market.

The very cornerstone of the capital market is simply this: at any one point in time, some segments of the economy have surplus capital (investors) while others in the economy have a use for that surplus capital (borrowers).

The Capital Market
The capital market, as it is defined, refers to the market that facilitates the transfer of funds from those who have excess to those in need (savers to borrowers).

One of the largest determining factors of the supply and demand for funds is the interest rate that governs the process. This provides a measurement for the reward of saving, while providing the cost of borrowing. The equilibrium interest rate is the point where there is a close balance between the amount borrowed and the amount saved. In economic terms, the interest rate is the “price” of borrowed money.

Canada’s Mortgage Market
In the past, banks primarily lent mortgage money from the deposit base of their customers. In today’s market this is increasingly no longer the case. The competition for deposits has now escalated to the point where there is no longer a sufficient deposit base for banks and trust companies to lend from. Today, much of the banks lending comes from their own ability to borrow from the debt capital market.

The debt capital suppliers have the primary responsibility of making sure that they preserve the capital of their investors while getting a fair rate of interest for the money they lend based on what it is lent for. The key driving forces behind the cost of that money (interest rate) is the relative creditworthiness of the borrower coupled with the expected rate of inflation for the period of time the money is being ‘used’.

Mortgage Pricing (rates)
As always, the risk return trade-off holds true in the marketplace. In order to lend money out to higher risk areas, the debt capital suppliers must be able to command a risk premium (extra return) for enduring that risk. This premium is factored in through a higher interest rate.

So how are almost perfectly secured investments like prime residential mortgage rates priced the way they are? The comparison is quite simple. Commonly in the financial markets, government backed financial instruments serve as the entry point being viewed as the risk-free investment. Governments have almost zero default risk through their ultimate ability to increase our taxes and control money supply (among many other variables).

In this case of fixed rate mortgages, that comparative instrument is the federal government bond. This bond represents a promise by the Canadian government to pay the interest stated and to repay the original capital at the stated maturity date.

Today, the largest determining factor is the relative price of the government bond for the term of the mortgage selected. To encourage those who invest in debt capital to invest in mortgages over government bonds there must be some kind of premium as a reward for the extra risk associated with investing in mortgages.

This risk in financial terms is referred to as the spread. The spread effectively determines the premium charged for investing in mortgages instead of government bonds. This spread must take into account all extra costs incurred to fulfill a mortgage portfolio as well as factor in a profit. What you will find is that these spreads generally remain fairly constant over the short term.

So, next time you want to predict a fixed mortgage rate movement spend less time watching the Bank of Canada (which impacts variable rates) and more time watching the movements in the bond market. While the bond market does trade on expectations, it is important to note that these expectations are typically the key driving force behind the mortgage rates we face. 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.

Of course – your chances of benefiting in the longer term go up significant when you work with a financial professional with understanding of capital markets and financial planning. If you take your financial goals seriously.

Do you want more personal financial health and clarity to achieve retirement goals?

Our team handles the mortgage financing on tens of millions of dollars of borrowing to invest transactions every year (quite literally hundreds of transactions every year). Each member of our team in an advisory role has formal personal finance training and an in-depth understanding of the borrowing to invest strategy. We are uniquely suited to assisting you with optimal debt structuring and setting up your access to capital for your personal borrowing to invest strategy.

No mortgage or financial planning team in this country does more borrowing to invest or borrowing for wealth creation than our team. We have the business track record and formal education to support your plan and to help you achieve your financial goals. Volatile markets create opportunities and we would love the opportunity to help you capitalize. Call our office today to discuss how we can help at 1-855-410-9905 or email

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