Who sets mortgage rates?
Here’s what controls the interest rate on your mortgage—and why that rate can rise or fall, even when the Bank of Canada rate is unchanged.
If you’re like most Canadians, buying a home is the largest purchase you’ll ever make in your lifetime. Since most people aren’t sitting on a large inheritance, you likely won't but a home with cash alone — you’ll borrow most of the money by getting a mortgage loan.
Small changes in mortgage interest rates can make a big difference in how much you’ll pay in monthly interest. That’s why it’s so vital that you understand what determines the interest rate on your mortgage.
Core factors in mortgage pricing
Think of a mortgage as a product like a latte or cappuccino. You are familiar with the idea that when a business sells you something, that they need to sell it to you at a price higher than their cost to make a profit. A lender profits on your mortgage because you pay more in interest (the price the lender charges you) than their cost to lend out the money.
So, what determines their cost of lending?
Core elements that of mortgage costs
Cost of Funds
Cost of Risk
Operating Costs
Cost of Funds
The cost of funds is the interest rate paid by a lender for the funds that they use in their business. Contrary to legend, lenders don’t have vaults full of cash to lend to borrowers. Instead, they borrow money from investors and then lend it to Canadians at a slightly higher interest rate.
The cost of funds for banks is slightly higher than the ‘riskless rate’. The riskless rate is the rate at which the Canadian government borrows money from investors. It’s called riskless because there is virtually no risk that the government can’t repay a debt. Canadian banks are very stable, so they are very close to riskless.
The largest Canadian banks (e.g., RBC Royal Bank and TD Canada Trust) can borrow from investors at a slightly better cost than smaller banks.
The riskless rate for a variable rate mortgage is the Bank of Canada Target Rate, set by the bank of Canada, and the riskless rate for a 5-year mortgage is the 5-year government bond yield, which is set by investors in the bond market.
That is why Mortgage Sandbox uses the Bank of Canada rate, and the Government of Canada bond yields to develop long term mortgage rate forecasts.
Cost of Risk
When a bank lends money, they take a risk that they will not be repaid. Non-payment, although infrequent, is very costly.
Imagine one borrower doesn’t repay a $100,000 mortgage. How much interest will they need to charge to other mortgages so that they can accept the with that one will go not be repaid?
The bank knows that sometimes mortgages will not be repaid, so they charge all mortgages a little extra so that they will have enough set aside to be able to absorb the cost of the bad mortgage.
To be fair to Canadians, lenders don’t spread the cost of a bad mortgage evenly across all borrowers. They try to charge the riskier mortgages more interest than lower-risk mortgages.
To assess the risk of a mortgage, they will look primarily at:
Borrower Risk
Purpose Risk
Property Risk
Product Risk
Borrower Risk
Borrower risk is an assessment of a borrower’s ability to repay. It looks at factors like their history repaying loans in the past, the stability of their employment, the volatility of their income (e.g., salaried vs. small business).
Often small business owners pay a slightly higher interest rate than salaried employees.
Purpose Risk
When borrowers find themselves in financial difficulty, they will always do their best to pay the mortgage on the home they live in, but they are more willing to let a vacation or rental property fall behind on payments.
Mortgages on rental properties and vacation properties often cost more.
Property Risk
A lot of people think real estate is riskless, but the value of a property is only realized when you sell it, and some homes can take a long time to sell. A lender may not have the luxury of waiting a couple of years to sell at the ‘best price’. Rural properties and luxury homes take longer to sell for full value. If you must sell one of these homes more quickly then you may have to sell at a discount.
Mortgages on higher risk properties get charged a little extra interest.
Product Risk
Product risk has to do with how the mortgage approval decision is made. For example, some private lenders make their decision to lend based entirely on the property risk and do not attempt to assess borrower risk. This is called an ‘asset-based loan,’ and it is often sought by people whose personal borrower risk would disqualify them at a traditional lender. Understandably, private lenders charge more for this type of financing.
Operating Costs
A lender has to take its annual operating costs and distribute them across all of their mortgages.
Operating costs include office leases, employee salaries and bonuses, mortgage broker commissions, and the cost of maintaining their website.
As you can imagine, traditional banks and credit unions with fully staffed branches on busy street corners will have a higher operating cost. A specialist mortgage lender that sells exclusively using mortgage brokers and provides service and support digitally on a website can avoid many of these costs.
Profit Margin
Your lender will do the math to make sure they charge enough for their mortgages to cover their cost of funds, cost of risk, and operating costs, and then they add a profit margin to the mortgage rate. That is how they calculate the lower limit for their mortgage rates.
Lenders usually advertise a rate that is 1% to 1½% higher than their lower limit, and borrowers then have to shop around and negotiate to arrive at a competitive mortgage rate.
Shop around, negotiate, get help from a mortgage broker
It can take a lot of work to get a competitive mortgage rate. You will have to do your homework and be willing to negotiate.
There are benefits and drawbacks to working with large banks, smaller or regional banks, credit unions, and specialist mortgage financing companies. Banks and credit unions have higher costs, but mortgage financing companies don’t offer the convenience of branch networks.
There is some subjectivity to assessing and pricing risk, and each lender has different costs. We recommend that you enlist the help of a mortgage broker who knows all the lenders and specializes in finding the best deal to fit your specific situation.
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