How do lenders decide what interest rates to charge borrowers? 2019-06-08 Jun 8, 2019
Lenders base fixed mortgage rates on bond yields. The most recent bond yields can be found on the Bank of Canada website. This site is really cool because you can track where interest rates have been for the last decade. You will notice that bond yields are far lower than the rates consumers are charged. That is because lenders add what is called a “spread” to these yields, which is essentially their gross profit margin.
For residential mortgages the “spread” is incorporated into the rate when it is quoted to the borrower. The only way for a residential mortgage borrower to know the “spread” is to check the bond yields himself. For commercial mortgages the rate is quoted in the form of “bond yield plus spread” and is therefore transparent. For example, a lender may offer you a commercial mortgage at “bond plus 175 basis points” which translates into “bond yield plus 1.75%” (every .01% is one basis point). When we negotiate with a lender for a better interest rate we are effectively asking them to “tighten the spread”. For example, on commercial mortgages we can negotiate spreads as low as 50 basis points over bond!
Bond yields have been pretty low lately because over the last 3 years people dumped stocks to buy bonds, thereby driving down bond yields. Many analysts believe that as stock market conditions improve, people will dump bonds to buy stocks. Subsequently, yields will rise and so will fixed mortgage rates. Here’s a trick: you can usually predict if fixed interest rates will change ahead of time by watching bond yields each day (like we do). It takes lenders anywhere from 1-5 days to react to changes in bond market conditions, giving you an opportunity to either “lock in” a variable mortgage if you think rates are heading up, or sit on the fence a while longer if you think rates are heading down.
Lenders base variable mortgage rates on the prime rate, which is also set by the Bank of Canada. Now things are a bit more complicated here: lenders borrow money from the Bank of Canada at this really low prime rate, then set their own really high prime rate, then subtract from their really high prime rate to set a borrower’s rate.
The prime rate has been pretty low recently because the government is concerned about weakness in the economy. Since most businesses borrow money from lines of credit based on prime, lowering the prime rate puts more money in their pockets and effectively stimulates the economy. Credit card borrowing is also closely linked to prime (although you wouldn’t know it the way credit card companies keep gouging consumers), so a lower prime should also put more money into consumers’ hands by lowering credit card payments, effectively offering economic stimulus. Keeping the prime rate very low for an extended period of time can overheat the economy and lead to inflation. However, many analysts believe that prime will remain low for quite some time because of recessionary fears and very little evidence of inflation on the horizon.