As many of you are aware, the Bank of Canada reviews the Canadian economy on a regular basis to help control inflation or deflation. Depending on how the economy is doing compared to the Bank’s expectations, the Bank will do one of three things. They can raise the Prime lending rate, leave it where it is or decrease it.
Last week the Bank reduced the Prime lending rate to 2.75% from 3% where it has been since September 2010. This rate reduction came as a surprise to most economists and has caused my clients to have many questions. Most of the questions revolve around how it will impact their mortgages.
Simply put – it won’t – at least not yet.
There are a several reasons for this. First of all, any changes in the Prime lending rate will only affect those clients in variable rate mortgages. Many people assume that when they read in the headlines about rate drops that it affects both variable and fixed mortgage rates. This isn’t true since each rate is driven by different factors. The fact that one moves doesn’t mean the other one will as well. I have seen many instances where they have moved in different directions.
The Prime lending rate is set by the Bank of Canada and historically lenders use the same rate to determine what the variable mortgage rate will then be. So far, not one single lender in Canada has reduced their rates from 3% to 2.75%. This is because we don’t borrow money from the Bank of Canada but from the banks. As a result, the banks can do what they please. So if your variable rate was Prime less .60% before the rate drop, for example, it is still at 2.40%. However, the banks make a good profit from mortgage lending and at some point, a lender will drop their Prime lending rate and the rest will follow.
With regards to fixed rate mortgages this drop in the Prime lending rate will have no
direct impact. Fixed rates are determined, not by the Bank of Canada, but by bond yields. Bond yields are a leading indicator of what fixed interest will do. So to get a heads up on what five year fixed rates will do, start following five year bond yields. Bond yields are a benchmark by which the cost of capital is determined by a bank at its lowest level of risk. Once the bank has established this cost, they set their own fixed mortgage rates. The bank makes money on the spread between the bond yield and the fixed interest rate.
However, the Bank’s unexpected drop may have an indirect impact on fixed rates. This
drop may affect the sentiments of people investing in bonds. Investors may see this drop as a lack of confidence in the economy which could cause them to start selling their bonds. As bonds are sold, their yield increases which would then cause an increase in fixed rates. So here we may eventually see a drop in Variable rates followed by an increase in fixed ones. Only time will tell on this!
If you have any further questions about rates, please contact me.