On October 23, 2024, the Bank of Canada (BoC) announced a significant 50-basis-point cut to its overnight rate, reducing it to 3.75%. This move reflects an effort to bolster the economy amid falling inflation, now below the target of 2%, and soften the impact of a challenging global economic outlook. Although this decision primarily affects variable mortgage rates, there are important misconceptions about its effect on fixed mortgage rates. Let’s dive into how this rate cut influences various sectors and explore the broader dynamics of today’s mortgage landscape.
How the Overnight Rate Cut Affects Borrowers
1. Impact on Variable-Rate Mortgages
Variable mortgage rates are directly tied to the Bank of Canada overnight rate overnight rate. A reduction in the overnight rate generally leads to a corresponding drop in the prime lending rate, which lenders use to set rates for variable mortgages and lines of credit. For homeowners, this means lower monthly payments, offering some breathing room in a higher cost-of-living environment.
For example, with this rate cut, a homeowner with a mortgage rate of 5.30% on a typical Canadian home valued at around $669,630 could see their rate drop to 4.80%. Using this new rate, the monthly payment would decrease by about $178—saving the homeowner more than $2,000 annually. This relief is particularly valuable for those on adjustable-rate mortgages who have faced significant payment increases over the past couple of years.
2. Impact on Fixed-Rate Mortgages: A Common Misconception
It’s a widespread misconception that the Bank of Canada overnight rate overnight rate directly affects fixed mortgage rates. However, fixed rates are more closely tied to bond yields. Specifically, five-year fixed mortgage rates often track the yield of five-year Government of Canada bonds.
Bond yields respond to market sentiment, inflation expectations, and interest rate trends. As inflation slows and expectations for further BoC rate cuts rise, bond yields have dipped below 3%. This trend may bring down fixed mortgage rates, which are already averaging around 4.49%. However, the influence of global financial conditions—such as inflation and employment figures in the U.S.—can also impact yields, keeping fixed-rate trends somewhat unpredictable in the short term.
Historical Perspective: Why Fixed Rates Are Now Lower than Variable Rates
Historically, variable rates have almost always been lower than fixed rates, offering borrowers the opportunity to save money by assuming the risk of potential rate fluctuations. The logic behind this is that lenders price in the risk of future rate increases when offering fixed terms. In normal conditions, borrowers who chose variable rates often paid less over time since the overnight rate remained low or stable for extended periods.
However, today’s market presents an unusual reversal. As of 2022 and 2023, variable mortgage rates have surpassed many fixed rates. The reasons for this shift are multifaceted:
- Aggressive Rate Hikes by the BoC: Over the past two years, the Bank of Canada raised rates multiple times to combat inflation, pushing the overnight rate to levels not seen since the early 2000s.
- Lagging Adjustment of Fixed Rates: Fixed mortgage rates tend to adjust more gradually based on bond yields, whereas variable rates adjust almost immediately following BoC announcements.
- Risk Premiums in Variable Rates: Given the economic uncertainty, lenders are pricing variable-rate mortgages with higher premiums to manage the risk of further fluctuations.
With inflation now under control and bond yields falling, fixed rates are more attractive than variable ones—an inversion of the usual trend. Borrowers must carefully weigh their options when deciding between fixed and variable terms, as further BoC cuts may eventually lower variable rates again.
Wider Economic Implications of the Rate Cut
1. Consumer Spending and Credit Growth
Lower interest rates encourage borrowing and spending. As variable rates drop, consumers may feel more comfortable taking on debt, whether through personal loans, lines of credit, or mortgages. This boost in credit growth could help spur economic activity, especially in sectors like retail and real estate.
2. Real Estate Market Reaction
Canada’s housing market is sensitive to interest rate changes. The recent rate cut may reignite demand in previously cooling markets. However, with many buyers expecting additional rate cuts, some may adopt a wait-and-see approach, delaying purchases to secure even lower rates in the near future. This dynamic creates a balancing act for the market, as sellers must navigate changing buyer behavior.
The Bank of Canada’s decision could also influence the behavior of those facing mortgage renewals. With many homeowners coming off fixed terms from five years ago—when rates were around 2-3%—they now face significantly higher renewal rates. The current rate environment may push some borrowers to explore shorter-term fixed products, hoping for better conditions in the next few years.
Challenges for Savers and Investors
While the rate cut benefits borrowers, it comes at a cost to savers and fixed-income investors. As banks lower prime lending rates, the interest paid on savings accounts, Guaranteed Investment Certificates (GICs), and bonds will also decline. This reduction in returns may prompt investors to seek higher-risk opportunities in search of better yields, potentially driving more capital into equities and real estate markets.
Navigating the Current Mortgage Landscape: Expert Recommendations
Given the shifting dynamics between fixed and variable rates, mortgage professionals recommend a strategic approach to borrowing:
- Assess Personal Risk Tolerance: Borrowers uncomfortable with uncertainty may prefer fixed-rate mortgages, locking in predictable payments.
- Monitor the Market Closely: As expectations for future BoC cuts increase, those opting for variable rates might benefit if rates decline further.
- Explore Hybrid Products: Some lenders offer mortgages that split between fixed and variable rates, providing a balance between stability and potential savings.
- Consult a Mortgage Broker: In a volatile market, brokers can help navigate options and secure the most competitive rates.
What Lies Ahead?
The Bank of Canada’s 50-basis-point rate cut marks a pivotal moment, signaling a shift towards more accommodative monetary policy. While borrowers with variable-rate loans stand to benefit immediately, the unusual situation where fixed rates are lower than variable rates complicates decision-making for new mortgages and renewals. Additionally, the interplay between bond yields and fixed-rate products adds another layer of complexity to the current mortgage landscape.
Homebuyers, homeowners, and investors will need to stay agile in this environment. Whether choosing fixed or variable rates, it’s essential to understand the broader economic context and market expectations. The BoC’s future rate decisions will continue to influence both mortgage rates and economic sentiment, with the potential for further reductions offering both opportunities and challenges across the financial landscape.
Sources: Bank of Canada, Hill Times, BlogTO.