Why do banks offer variable interest rates?
A variable mortgage rate is a floating interest rate that tracks the bank prime rate and is offered for home loans, like mortgages and HELOCs, at a discount below or a premium above prime.
Flow-through funding costs. A variable rate floats — changes in the Bank of Canada policy rate flow right through to your mortgage or HELOC payment. That flow-through means a lender shifts some funding-cost risk to you instead of absorbing it itself.
Short-term funding. Banks fund a portion of their mortgage portfolio with shorter-term money (like deposits and wholesale borrowing) that reprices often, keeping that part of their portfolio closely tied to the rate market.
Rate discount appeals to certain borrowers. But because the borrower takes on the risk of change, this rate type is typically set about 0.25%–1.0% lower than a 5-year fixed mortgage rate.
The variable loan pass-through may sound too convenient for your bank, but consider the consumer side — many mortgage borrowers want to access those lower variable rates and accept the risk of change, potentially saving more over the mortgage lifetime by riding prime rate changes to (ideally) come out ahead on the mortgage math.
How are variable mortgage rates set?
BoC rate >> bank prime rate >> variable mortgage rate
- The Bank of Canada sets its rate (raises, holds, or cuts) 8 times a year on set decision dates.
- Banks usually follow within a day or two (at most) to adjust their prime rate, which is currently set 2.2% higher than the BoC policy rate.
- Variable-rate products are then set above or below prime, depending on the lender's presets.
- If prime changes, your interest rate will change after the next full payment cycle, affecting your payment.
How does a variable rate work for your mortgage?
With a 5-year variable rate, your discount off or premium above prime stays intact, but your interest costs can fluctuate during your mortgage term according to prime rate movements, which:
- Change your payment amount if you have a floating-payment Adjustable-Rate Mortgage (ARM)
- Change your amortization and mortgage balance if you have a static-payment Variable-Rate Mortgage with a big bank (VRM)
If you need to break your mortgage mid-term, a shorter variable-rate term (less than 5 years) may be offered for the remaining period.
Most lenders allow you to lock into a fixed rate during your term, penalty-free, if you decide you can't stomach the variable-rate risk of change.
Why do banks offer fixed rates?
A fixed mortgage rate stays the same for the duration of your mortgage term, meaning your payments won't change.
Demand. Mortgage lenders offer fixed mortgage rates as a competitive necessity, driven by demand — most borrowers want interest-rate and payment certainty, especially for a large financial commitment like a mortgage.
Banks can lean on the bond market. As the standard for long-term borrowing, the bond market lets lenders fund fixed-rate mortgages that match a bond's term.
Fixed rates can have terms ranging from 3 months to 10 years (or more). However, a 5-year fixed-rate mortgage term is standard, and it typically offers the most competition among mortgage lenders for their lowest advertised rates.
Profit margin. Banks set fixed rates above their funding cost (a spread), so it's a reliable revenue stream no matter how rates move afterward.
A fixed rate costs you more because you're paying for mortgage peace of mind for months or years. The lender prices in a cushion in case rates rise during that time. A variable rate skips that cushion — you take on the risk yourself, so it starts cheaper.
How do government bonds influence fixed mortgage rates?
Banks buy bonds from the Bank of Canada as a low-maintenance (less costly) source of fixed-interest income. They also use fixed mortgage rates as an income source, but mortgages are higher maintenance compared to bonds (it costs more to operate mortgage loans).
Fixed mortgage rates compete on similar terms with bonds to attract the capital lenders need (e.g., 2-year, 5-year), so lenders set fixed mortgage rates at a higher point than less-costly bonds to keep these two income sources on par.
How are fixed mortgage rates set?
Bond yield by term >> fixed mortgage rate by term
Fixed mortgage rates are set higher than bond yields at a (typical) spread relationship of 1-2%, using the 5-year yield as the industry benchmark.
The 5-year fixed-rate mortgage is the standard term that banks compete on, and so watching 5-year bond yields can offer a good indication of where fixed rates may be going.
- When 5-year bond yields rise, fixed rates usually rise too, if the trend continues.
- When 5-year bond yields decline, fixed rates usually come down too, though banks react more slowly to ensure the trend is holding.
- Bonds trade daily — 5-year mortgage rates can move at any time.
- Yield positions can determine where prime rates may be headed.
When you sign up for a fixed mortgage rate, it's yours for your full term and won't change until it's time to renew.
Why interest rates can't just always stay low.
Lower interest rates typically stimulate the economy. So if they stay low regardless of economic conditions, inflation would climb as demand for goods and services increases and supply decreases.
Rising prices can severely damage the economy — they eat up your paycheque, erode savings, leave people and businesses with less to spend and invest, and can even cost elections. Unchecked inflation can inflict global damage and potentially threaten long-standing fiscal mechanisms, like the bond and stock markets.
The Bank of Canada's primary purpose is to keep inflation in check, using a 2.0% target for the CPI basket of price-change measures it uses. It raises its policy rate when it believes the economy or inflation is growing too rapidly.
No one likes rising interest rates, but they're a tried-and-true mechanism that everyday life in Canada is built on, and they rely on alignment between the world's monetary and government-related policies.
