How are mortgage interest rates determined?

It depends on whether we’re looking at variable or fixed rates, but in both cases they heavily depend on the lender’s cost of borrowing. This is the amount a lender pays to borrow money; then they add on a premium as their profit margin, and lend out to home owners and buyers at that rate.

Variable rates “float” because they are driven by short-term lending rates - especially the Bank of Canada’s overnight lending rate. As this rate changes, it affects the lender’s own prime lending rate, which then changes the variable rate borrowers are paying. This is why changes by the BoC will immediately be felt if you have a variable rate, but not if you have a fixed rate.

Fixed rates offer additional security because the rate is locked in (e.g. most commonly 5 years in Canada). Because you have this certainty, it costs you a little more, and is typically reflected in higher rates compared to a variable mortgage.

Lenders fund fixed mortgages by purchasing long-term bonds at a wholesale rate, to match the length they are in turn lending to the public. Therefore 5 year bond prices drive 5 year fixed mortgage rates, and so on. Just like with variable rates, they will add a premium to their own cost of borrowing (for their profit margin), which will be the mortgage rate offered to home buyers.

One other important consideration is around timing. Long-term bond prices are often considered a leading economic indicator and reflect what the investing market expects to happen in the future - which affects Fixed Mortgage rates. Rising bond prices (increased demand) suggest better economic performance, decreasing prices suggest slowing or declining growth.

The prime overnight lending rate, in contrast, is based on the immediate term - what lending conditions look like today and tomorrow - which as mentioned above affects Variable Mortgage rates (and HELOCs, which are also often based on a bank’s prime rate).