Whether this is your first or fourth mortgage, a common question that mortgage specialists are asked is “how are mortgage rates calculated?”. In this article, we break down how rates are set, influences on the rate and how it affects your mortgage. Let’s dive in with the ‘starting point’ or the Prime Rate. 

The Bank of Canada Prime Rate is the ‘starting point’ for all banking and financial services in Canada - it essentially sets the floor/lower limit for what is possible when it comes to both depositing and borrowing money, like you would for a mortgage.

What is a fixed v. variable mortgage rate?

Variable and fixed-rate mortgages are the two primary rate types of mortgages in Canada. Each has its advantages. 

Fixed-rate mortgages guarantee a fixed interest rate for the length of your term and therefore a payment amount which stays consistent over the term of the mortgage. 

With a variable rate mortgage, the interest rate changes according to your bank's mortgage prime rate. Monthly principal payments remain steady over the course of your term, however the amount that goes toward interest on the loan will fluctuate with the Bank of Canada’s prime lending rate. If you have a variable-rate mortgage and you would prefer to lock your rate into a fixed one, some variable-rate mortgages allow you to lock in to a fixed rate at no penalty. 

How the prime rate is set

The Bank of Canada (BOC) changes the Prime Rate in order to influence how banks, and the clients of those banks, act. When the BOC increases the Prime Rate, it becomes more expensive for a bank to borrow money, which means it becomes more expensive for clients of that bank to borrow money. The BOC hopes that this change in the cost of borrowing (and the corresponding increase to savings accounts) encourages folks to spend less and save more.

Because of this, even though each bank in Canada will hold their own Prime Rate, it is directly influenced by the Bank of Canada’s Prime Rate and these rates are largely the same across Canada's chartered banks.

Why does the prime rate move?

If you have loans, lines of credit or variable mortgages tied to prime, you may be wondering what the prime rate is and how it impacts your finances.

After a period of low interest rates during the pandemic, (from 2020-2022) spring of 2022 saw the Bank of Canada begin a series of rate hikes that have led to our current Prime Rate of 5.00%. These hikes by the Bank of Canada have been primarily to fight rising inflation in the economy. Essentially the Bank of Canada raises interest rates to encourage Canadians to save their money (by offering high savings rates and more expensive loans) as a means to cool spending and bring down inflationary pressure. Consumers spending less and saving more means producers will charge less for their goods and that slows inflation.

When the prime rate increases any variable rate debt you may have (ie. credit cards) become more expensive, whereas fixed rate loans (perhaps your mortgage) will remain the same for their term. In this instance the Prime Rate increase would only affect a new mortgage, or your renewal rate if your term was ending soon. 

Influences on the final rate

If you have a variable rate loan, be it a mortgage or credit card, changes in the prime rate will have an immediate effect on your borrowing. In a scenario where prime is increasing, this change will either increase your payments (credit card) or increase the amount of your payment that is going to interest (variable rate mortgage).

If you have an active fixed rate loan, there would be no impact to your current loan. What would change is the next loan or renewal you have with the bank, as the cost of the loan has become more expensive  - because the rates they are paying clients to deposit money at the bank in the first place has also gone up.
 

How the prime rate affects your mortgage

Your borrowing, whether variable or fixed, is affected by the Bank of Canada's Prime rate.

If you have a variable rate mortgage, your interest rate is directly tied to this number (ie. Prime +0.5) and if the BOC changes the prime rate, the rate you are paying on your mortgage also changes.

If you have a fixed rate mortgage, your interest rate won't change, but what has changed is the baseline of the market - which has either shifted up or down, depending on the direction of the BOC change. As mentioned earlier your current loan would be unaffected, but the effect would be felt on the next fixed rate loan that the bank writes.