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Why Are Fixed Rates Going Up if the Bank of Canada Hasn't Budged?

You may have noticed that fixed rates have steadily risen over the last several months and continue to do so.  As recently as mid-June five year fixed rate mortgages below 3% were quite common.  Now, 3.69% is considered a bargain.  Even BMO’s Five Year Low Rate Mortgage (the one that sent Jim Flaherty into a tizzy when it went to 2.99%) is now at 3.89%.  During the same period the Bank of Canada has made two interest rate decisions and, as with every previous interest rate decision since September 2010, they left their key lending rate unchanged, and appear to have no intention of raising it for at least another year.  So why are fixed rates going up?

Variable Rates and the Bank of Canada:

The Prime Rate, to which each lender’s variable rates are tied, is determined by the Bank of Canada’s interest rate policies.  Contrary to what some believe, the Bank of Canada does not set the “Prime Rate”.  Each lending institution sets its own Prime Rate.  But each lender’s Prime Rate is directly affected by the Bank of Canada’s key overnight lending rate and, with very few exceptions, moves in lock step with that rate (currently 2% higher).  The last time the Bank of Canada changed its key rate was in September of 2010 when it raised the rate a quarter percent from 0.75% to 1.0%.  Within a few days of that rate hike the Big Banks and other lenders moved their Prime Rates from 2.75% to 3.0% where they remain today. 


Fixed Rates and the Bond Market:

Fixed rates, on the other hand, are governed primarily by bond yields which, although heavily influenced by what is happening elsewhere in the economy, are not strictly tied to the Bank of Canada’s interest rate policy.  When determining the rate for a fixed rate mortgage, a lender will look to the yield on the corresponding government bond.  Although lenders may also fund fixed rates from a variety of other sources, bond yields are looked to as the benchmark for determining a lenders cost of funds for fixed rate mortgages.  Over the past 4 months bond yields have soared by over 1% and fixed rates have followed suit, rising by almost as much.  


Is This Another False Start? 

There have been occasions when fixed have risen by as much as .50% in the last couple of years and on each of these occasions they eventually fell back down.  Whether the current rally will also collapse has yet to be seen.  Experts indicate that we are feeling the spillover effects of the proposed cutting back by the U.S. central banks of its bond buying spree.  With a lower demand for bonds, prices sink and yields increase.  If the Fed continues to taper its economic stimulus we may see a continued rise in rates.  Alternately, the current jump could just be a knee jerk over-reaction and bond yields may settle back again before making another continued run.  Analysts will be hanging on Bernanke’s ever word this week for further clues.


Fixed or Variable, That is the Question:

There’s no denying the fact that at current rates, the variables are looking far more attractive than they did a few months ago.  As recently as early June the premium you’d pay for the comfort of a fixed rate over a variable was about .25%.  Not bad considering you could tuck that rate away and not think about it for five years.  Even 10 year fixed rates were available for about what you’d now pay for a five year.  Now, however, the difference is closer to 1.0%.  There are definitely short term savings to be had in a variable.  At current rates, on a $500,000 mortgage you’ll pay approximately $5,000 less in interest over the first year, assuming the Prime Rate doesn’t move.  But beyond the next year or two it is anybody’s guess.  As always it depends on your risk tolerance and whether your budget can absorb the expected, and unexpected, rate hikes when the Prime Rate starts to move.

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John Freeland Smith


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