Who decides when interest rates rise or fall?
by Gregory van Duyse
To choose the right mortgage strategy and save lots of money (see “Choosing your mortgage strategy”), you must first understand the circumstances that push banks and mortgage lenders to raise or lower interest rates.
Fiscal policy of the Bank of Canada and the obligation market are both subjects that could fill several books, so we’ll approach the subject simply. |
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| We have the impression that it is banks who decide to raise or lower interest rates for the mortgage market and in a sense it is true. They make the final decision to react to other factors.
First, let’s separate the subject of interest rates into two parts:
- The variable rate mortgage, which is controlled by the prime rate.
- The fixed rates or long-term rates of various mortgage lenders.
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The prime rate and the Bank of Canada.
The base rate is controlled by the Bank of Canada, and it has a direct impact on the prime rate of all the major Canadian banks.
How does a variable rate mortgage works
Many people let themselves be influenced by variable rates: “Wow, I got a rate of 4.75% for 5 years!” (when the 5-year fixed rate is 5.40%). What you must understand is that variable rates rise and fall with the prime rate. If the prime rate is 5.50% and the client has a rate of 4.75%, then it is more precise to say that he received a variable rate of “the prime rate minus 0.75%”. When the prime rate goes up by a quarter of a point (to 5.75%, for example), his mortgage rate will be 5.00% over this period (+/– 6 weeks).
The prime rate is established eight times per year at precise intervals. It’s at this moment that David Dodge, governor of the bank of Canada, decides to raise, lower, or stabilize the base rate and the prime rate until the next meeting.
The following factors seem to influence the prime rate:
- Changes in the consumer price index of Canada (inflation). When the inflation rate is more that 2% per year, the interest rates have a tendencies to increase.
- Changes in the Canadian economy (GDP).
In general, when the economy is weak and inflation is under control (1% to 3% annually), the Bank of Canada tends to reduce interest rates to stimulate the economy.
The inverse tendency also exists. When the economy is strong (which often drives the inflation rate upward), the Bank of Canada raises interest rates to calm the economy and the consumer.
Here is a graph of the prime rates over the past 10 years.
[Figure heading: Base rates of large Canadian chartered banks from 1996 to 2006;
x-axis label: Month and year.]
The fixed or long-term rate.
Each lender establishes its own fixed rate.
To understand why interest rates are increased and decreased, it is important to remember that banks periodically sell their mortgage portfolios on a secondary market.
Now when an investor buys portfolio of mortgages on the secondary market sees the interest rates increase on the bond market, he expects to get a higher rate for his mortgage portfolio. If the investor expects a higher rate, then the bank or mortgage lender has no choice that to increase the interest rates that they offer their clients. It’s a chain.
The opposite (when rates go down) is also true.
In conclusion, whether for variable rates or for longer-term fixed rates, the interest rate of your mortgage will rise and fall largely according to the fiscal policy of the Bank of Canada. When Mr. David Dodge decides to raise the rate, it is often only a question of time before the bond market follows (and even sometimes anticipates) this trend and mortgage lenders react by raising their fixed rates.
Everything is linked!
The simplest solution is to choose an accredited mortgage counselor who understands how interest rate fluctuates. He will be able to guide you in making important choices:
- Choosing the right mortgage strategy for your needs. Far from the most important!
- Choosing the lender who will offer you a mortgage corresponding to your strategy, at a very good interest rate.
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