Fixed vs. Variable Mortgage Rates
One of the first decisions home buyers and mortgage shoppers face is whether to select a fixed mortgage rate or variable mortgage rate.
With a fixed mortgage rate, the mortgage rate and payment you make each month will stay constant over your mortgage term. With a variable rate, however, the mortgage rate will fluctuate with the prime lending rate as set by the Bank of Canada.
You can think of the difference, or spread, between variable and fixed mortgage rates as the price of insurance that lending rates will not increase, more or less. When interest rates are low and are not expected to fall further, it is generally advised to lock in a fixed rate, as variables rates will, at best, stay the same, or increase.
On the other hand, if you expect interest rates to fall with some certainty, then a variable rate is preferred, as you will be able to absorb the benefit of paying lower interest. Similarly, if the difference between the variable rate and the fixed rate is significant, it may not be worth paying the premium for the stability protection of a fixed rate.
How Variable Mortgage Rates are Set
Fixed mortgage rates follow the pattern of Canadian Bond Yields, plus a spread (or profit), where bond yields are driven by economic factors such as unemployment, export and inflation.
Variable mortgage rates are driven by the same economic factors, except variable rates fluctuate with movements in the prime lending rate, the rate at which banks lend to their most credit-worthy customers. Variable mortgage rates are typically stated as Prime +/- a percentage discount or premium. For example, a variable rate could be quoted as Prime -0.5%. So, when the prime rate is, say, 3%, you will pay 2.5% (3% - 0.5%) interest.
The Bank of Canada adjusts the prime rate depending on the state of the economy, as determined by the economic factors introduced above. global combinations of unemployment, export, and manufacturing values shape the inflation rate. Generally speaking, when inflation is high, the Bank of Canada will increase the prime rate to make the act of borrowing money more expensive. Conversely, when inflation is low, the Bank of Canada will decrease the prime rate to stimulate the economy and improve the attractiveness of borrowing.
In terms of the discount/premium on the prime rate applied to variable rates, mortgage lenders set this based on their desired market share, competition, marketing strategy and general credit market conditions. These are the same factors that drive the spread between lenders' fixed mortgage rates and bond yields.