New single family houses billed as estate cottages are seen in an aerial view, in Delta, B.C., on Aug. 12.DARRYL DYCK/The Canadian Press
Mortgage borrowers across Canada are likely feeling hopeful. With the central bank’s latest interest-rate cut, the benchmark cost of borrowing has dropped a cumulative three-quarters of a percentage point since June, bringing lenders’ prime rates – and by extension variable mortgage rates – down with it.
But borrowers may be surprised to learn that they won’t necessarily get the Bank of Canada’s full discount. That’s because it’s common practice for lenders to slash the spread to prime on variable-rate borrowing products, when interest rates are trending lower.
To understand how this could affect you as a borrower, let’s take a look at how variable mortgage rates are priced, which is based on whatever the lenders’ prime rate is, plus or minus a percentage. For example, let’s say you qualify for a five-year variable-rate mortgage rate with a spread of prime minus 1.15 per cent.
Assuming the lender’s prime rate is currently 6.45 per cent, that leaves you with a rate of 5.3 per cent. Now let’s say the BoC cut its benchmark rate again by a quarter-percentage point, and the prime rate falls to 6.2 per cent – that same mortgage rate would now be to 5.05 per cent (6.2 - 1.15).
But your lender decides to reduce their spread by 20 basis points, meaning their variable mortgage rate is now based on prime minus 0.95. The resulting mortgage rate is now 5.5 per cent for a new applicant, based on a 6.45-per-cent prime rate. If there was another quarter-point cut, the rate would lower to just 5.25 per cent. That may seem like a small difference, but can translate into thousands more paid in interest over the lifetime of the mortgage.
Lenders do this for a number of reasons. As a business, protecting revenue comes first and foremost and, when interest rates are already low or falling, they don’t need to price as aggressively to win over variable borrowers. The opposite occurs when central bank rates are on the rise – lenders will improve their spreads to prime to counter waning borrower demand.
It’s a pattern seen in every rate-cutting cycle – even during the emergency rate cuts at the start of the pandemic lockdowns. This time around, the spreads started narrowing in July, as the BoC delivered its second quarter-point cut.
From a borrowers’ perspective, this seems unfair. But, given the economic challenges posed by the large number of mortgages coming up for renewal, it also seems counterintuitive.
A total of 2.2 million loans, accounting for 45 per cent of all outstanding mortgages, are coming up for renewal in 2024 and 2025, according to a recent report from Statistics Canada. The report also finds that 1.3 million households bought their first home between 2018 and 2022, when mortgage rates were considerably lower.
These borrowers, many of whom are now ending five-year terms, are renewing in a much higher interest-rate environment. “This increase in mortgage costs will squeeze households’ budgets and savings further, particularly for those that took on large amounts of mortgage debt when the cost of borrowing was low,” the report says.
An analysis written by Canadian Imperial Bank of Commerce senior economist Andrew Grantham raises similar concerns: as a result of rising interest rates, the smallest amount of mortgage principal paid among borrowers has reached a low not seen since 2012. He also finds that today’s active mortgage borrowers are also less likely to have a savings cushion to soften the blow of renewing into a higher rate.
The saving grace, Mr. Grantham writes, is that the current rate-cutting cycle will soften the blow, with perhaps deeper cuts required from the central bank.
“As interest rates come down, those households that have been incentivized to save more and take on less debt may up their spending and help drive an acceleration in household consumption and residential investment,” he writes. “However, the wall of mortgages coming up for renewal next year and in 2026 remains a threat, and the Bank of Canada may have to take interest rates slightly below neutral to mitigate the risk at that time.”
Dwindling spreads will only make it tougher for the central bank to counter this risk.
So, as a borrower, what’s your move? For those shopping or coming up for renewal, a rate hold is your best bet. This will guarantee you access to the best spreads to prime available today, even as lenders are poised to narrow them further amid future rate cuts.
It’s a way for variable borrowers to stay one step ahead of the game – a rare opportunity in today’s volatile rate environment.
Penelope Graham is the director of content at Ratehub.ca.
