What Determines Mortgage Rates?

Mortgage interest rates play a significant role in determining your budget and overall long-term cost of purchasing a home. When you get a loan, the lender is taking a risk on you. The higher the risk, the higher the cost of borrowing money or the interest rate. In general, mortgage interest rates are determined based on how much risk the lender think it is taking on you and the economy.

Mortgage rates are determined by a number of different factors, including economic factors and government financial policies. Below are the major factors that determine mortgage rates.

Inflation

Inflation, which is the general increase in prices of consumer goods and services over time, can be caused by increased demand for goods (such as when the economy is doing well and people have higher purchasing power to purchase goods) or increased production costs. A moderate level of inflation is healthy for the economy. However, inflation can erode the purchasing power over time, because goods and services become more expensive (you get less for the same amount of dollars). Inflation is a critical factor for mortgage lenders, because mortgage lenders have to maintain mortgage interest rates at a level that is at least sufficient to overcome the erosion of purchasing power through inflation. This is to ensure a certain level of profit from the interest returns.

Example: If annual inflation is at 2%, then mortgage lenders need to offer mortgage rates at a minimum of 3% in order to get a profit of 1% interest rate return. Higher mortgage rates would return higher profits above the inflation rate.

Therefore, mortgage rates offered by lenders usually move in momentum with the overall inflation rate of a nation.

Economic Growth and Employment Rate

Gross Domestic Product (GDP) is one of the main indicators of economic growth. A combination of economic growth and employment rate indicators influence mortgage rates. Higher GDP or economic growth generally results in higher employment rate and higher incomes, resulting in higher levels of consumer spending. In turn, more consumers seek mortgage loans for new home purchases. In other words: When the economy is doing well, more people are employed and their incomes are higher. When people have more spending money, they purchase more – including real estate, and the demand for mortgages goes up. This follows the “supply and demand” principle. Lenders have only so much money to lend out. With limited supply and increased demand, lenders need to increase mortgage rates (the same way that prices of goods go up when demand increases).

When economic growth is negative, employment rate and wages decline, resulting in decreased demand for mortgages and new home purchases. This results in lower mortgage rates.

Housing Market Conditions

Mortgage rates are also impacted by the trends and conditions in the housing market. The decline in volume of home purchases (when fewer homes are being built or on the market for resale), there is a decrease in demand for mortgages. This results in mortgage rates decreasing. When more people opt to rent instead of buy, this also puts downward pressure on mortgage interest rates. Lenders monitor housing market conditions and house buying demands closely in order to set their mortgage rates accordingly.

Bond Market

The biggest factor in determining a fixed rate mortgage rate is the bond market. Banks and investment firms use the bond market to determine their fixed mortgage rates. Banks use bonds and mortgages to generate profit. In general, bonds have little to no risk for banks. Bonds are a no-cost investment for banks, with a guaranteed yield of at least a minimal profit. On the other hand, mortgage carries risk because there are costs associated with vetting the lender, approving, and setting up the mortgage. There is no guaranteed profit, and the bank is at risk of losing money if the borrower defaults on the mortgage. Therefore, banks determine fixed mortgage rates by calculating the money they have invested (bond rates) and using forecasted earnings from bond investments to cover the costs and possible losses incurred through mortgages. As a result, bond rates and fixed rate mortgages have an inverse relationship (the higher the bond rates, the lower the fixed mortgage rates become).

Bank of Canada’s Monetary Policy

Although the Bank of Canada does not set mortgage rates directly, the Bank of Canada’s monetary policy in adjusting the money supply upward and downward have a significant impact on the interest rates available to the public for borrowing. Increased money supply puts downward pressure on interest rates, while tightening money supply puts upward pressure on interest rates.

Variable rate mortgages are impacted the most by changes in the Bank of Canada’s monetary policy. Interest rates on variable rate mortgages change based on the Bank Rate and the overnight rate, which are set by the Bank of Canada. Every bank uses the overnight rate to determine their own prime rate. Variable rate mortgages fluctuates with the bank’s prime rate.

In conclusion, mortgage rates are determined by the basic principle of supply and demand. Economic factors such as inflation, economic growth, employment rate, purchasing power, bond market, and housing market conditions also play significant roles in determining mortgage rates. Note that personal factors such as credit score, income stability, and your own financial health also determine the mortgage rate and approval that you receive from a lender.