As per usual, I am inspired to write a blog when I see mass amounts of mis-leading information shared on social media. Some inadvertently mis-leading and some with pure intent to make the phone ring. Most, as with many things in life, are simply down to good intentions and bad (or limited) information. Today, I'd like to unpack why and how a Bank of Canada rate announcement impacts mortgages and interest rates. And more importantly how it might not even affect certain rates at all. Teaser sentence has you hooked? Excellent.
Let's start with the function of the Bank of Canada.
To simplify things; the Bank of Canada creates the money for Canada. They then lend this money to the banks at what is called the 'Overnight Lending Rate' or 'Key Interest Rate', this is the interest rate they charge the banks to borrow money from the BoC.
The BoC (among other duties like funds management for the Government of Canada) is fundamentally responsible for managing inflation in the Canadian economy. They do this through a series of monetary policy tools, most notably, by increasing or decreasing the Overnight Lending Rate. In periods of heightened inflation (like we saw through 2022 and 2023) the BoC will increase the overnight lending rate in an effort to combat inflation. By increasing this rate, it costs more to borrow funds and in turn, Canadians borrow less which helps curb inflation.
In times when inflation is low, they decrease the overnight lending rate, reducing the cost to borrow, which in turn encourages borrowing and helps push inflation upward. Some inflation is a good thing, but managing a reasonable level of inflation is the primary objective of the BoC.
This is where we now sit, the BoC is ready to maintain inflation in the 2% range and future rate announcements will now be set with the goal of maintaining the current inflation rate. And this is a tough job for the BoC because rate changes take an average of 6 - 8 months to have an impact on inflation, meaning that current inflation numbers today are as a result of BoC decisions made last spring. And today's rate announcement will have an impact on the markets in the coming spring. This 'look forward' approach means that the BoC has a lot of guessing to do - albeit with some of the top paid economists in the world doing the guessing.
The Overnight lending rate is the rate which the banks pay to borrow money from the BoC. The banks, then mark that up and lend money to Canadian consumers based on their prime rate for many lending products (but not all).
Prime rate, while universally most lenders maintain the same, is not set by the BoC. It is set by the lenders themselves and not all banks/lenders have the same prime rate or they might have different prime rates on different products. Which can be tricky for clients comparing a rate discount at one lender to a rate discount at another lender. One may appear to be a better deal, but they end up being the same rate or worse if that lender has a higher prime rate.
Prime rate lending is used for many types of loans and mortgage products. This is what the interest you earn in your savings account is based on. What you would pay interest based on in your line of credit. And what variable rate mortgage products are based on. This type of lending is expressed as a discount or premium to the prime rate.
For example, an unsecured line of credit may have a rate of Prime+2.00% (2% above the current prime rate). A variable rate mortgage might have a rate of Prime-.85%. A secured home equity line of credit might have a rate of Prime+.50%. In these products, you are locking in the discount or premium to Prime and your rate fluctuates as the prime rate changes at that lender which in turn can mean that your interest payment also fluctuates.
One thing to note, because Prime is set by the individual lenders and not the BoC themselves, often we see lenders take a few days to adjust their prime rate after a BoC rate announcement. Sometimes a rate change doesn't take effect until the next scheduled payment on a debt rather than immediately. And in some instances the rate is changed the same day within hours of an announcement. It really varies depending on the lender.
Variable Rate mortgages have 2 different options. One where the payment changes when there are changes to the Prime rate, and the other where the payment stays the same but the portion of the payment that goes towards interest changes. So depending on the lender, you could be in a variable rate mortgage where your payment doesn't change, just more or less of the payment is going towards paying down the mortgage faster or slower. Or you could see your mortgage payment change with every announcement.
As a result, a BoC rate announcement day might have no bearing on your actual payment that comes out of your account despite being in a variable rate mortgage product. And if you are in a fixed rate mortgage product, they will have no bearing whatsoever to your existing mortgage payment and this is usually where the confusion comes from.
Fixed rate mortgage products are not tied to the Bank of Canada announcements and this seems to be the biggest misconception that I come across when rate announcements days are here. Advertisements that 'rates are dropping' usually lead consumers to believe this means fixed rates. And when the Prime Minister tweets that interest rates were cut to 3.75% without any context, social media frenzy ensues. So to clarify, when Trudeau tweets about a rate at 3.75% - he is referring to the Bank of Canada overnight lending rate. As of the day of writing this post, the prime rate is 5.95% with most institutions and the average interest rates on fixed rates are still in mid to low 4's with variable rates in the mid to low 5's.
I'm sure you can see why good intentions can cause confusion among the public when they call their bank and are quoted rates much higher than 3.75.
So if the Bank of Canada doesn't affect fixed rates, what does? Glad you asked.
Fixed rates are based on the Canada bond market of corresponding maturity. Notably, the 5 year bond yield affects the 5 year fixed rates.
Bonds are not reflective or impacted by the Bank of Canada and instead are based on market factors and move independently of BoC announcements.
Bonds are based on the market's reaction to economic factors like inflation numbers, job numbers (both Canada and US) and most notably the change in investors perception of risk and other indicators like US election results, the possibility of recession, the probability of war and so on. These numbers can change at any point and are often influenced prior to an anticipated BoC rate announcement based on the same factors that lead to a BoC rate decision.
For example, inflation numbers came out Oct 15 indicating that inflation was below target at 1.6%. As a result, bond yields took a slight drop on Oct 16 through 18th and then recovered on the 21st. Bonds were already impacted by the inflation numbers in anticipation of the BoC rate announcement. As a result, fixed rates have already been priced based on the current bond yield and so the rate announcement made no major impact today.
This market changes in response to investors perception of risk and so tomorrow or a month from now might see new information which changes things but as of today, no real change.
So while the same economic factors that affect the BoC's decisions also impact the bond market, and they often move in tandem or in the same general direction, many people confuse a BoC rate announcement with changes to the fixed rate market. Sadly no, a .50% drop in the overnight lending rate does not mean fixed rates have dropped .50% as well.
Sometimes, yes, the fixed rates react to a change in the overnight lending rate with an unexpected dip in the bond as a result of a rate announcement, however the 2 factors are not tied hand in hand the same way that variable rate mortgages are linked to the BoC.
How can you make the right decision about which rate to choose?
I get asked this question all the time, almost daily. I sure do wish I had a crystal ball to predict where rates are going but my stock answer to everyone is that all we can do is make a decision based on the information we have today. In the lifetime of your mortgage you will go through many mortgage renewals, typically 5-8 depending on term lengths and which amortization you have. And some of those terms you might pay more and some you might pay less. While the intent is to always get the lowest rate, you will inevitably win some years and lose some years over the 25-30 years you have a mortgage. There is no right or wrong answer and trying to time the market or predict where rates will be in 3-5 years from now is an impossible task. Take Covid for example, in November 2019 clients were happily taking 5 year fixed rates at 3.29% with no way of knowing that by October 2020 that same mortgage would be priced at 1.84%. And clients who took variable rate mortgages and watched them drop as low as 1.2% would have never predicted that in 2022 those rates would climb to 6% and are now watching them drop back down.
Your mortgage is a long term debt, and just like an RRSP or investment product there will be high's and low's where you ride the wave over the long term and coming at it from this perspective will alleviate a lot of stress you might be feeling in trying to make the 'right' decision.
Making sense of which rate to choose depends on many factors which many times has nothing to do with the actual interest rate and everything to do with the risk exposure to penalties in the event you break the term. Talk through your plans with your favorite mortgage broker and go with your gut instinct.
In the end, it is your mortgage and you need to feel comfortable with the payment, the rate and the risk.
As always, if you have questions about this or any mortgage topic, feel free to reach out to me at Jill@JillMoelleringMortgages.com or call me at 780-720-4034
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