The Rate-Setting Process: Bank of Canada to Your Mortgage

How Mortgage Rates Are Formed: The Technical Chain

While most borrowers see a single rate quoted on their mortgage offer, the actual rate-setting process is a multi-layered chain involving:

• Macroeconomic indicators

• Central bank decisions

• Financial market behavior

• Lender-specific cost structures

• Borrower and loan-level factors

This article breaks down how those layers connect—and how they translate into the rate you're offered.

Step 1: The Bank of Canada’s Policy Rate (Overnight Lending Rate)

At the foundation is the Bank of Canada’s overnight rate, which influences the prime lending rates used by banks and mortgage lenders.

• When the policy rate rises, lenders typically raise prime, increasing variable mortgage rates.

• Conversely, when the Bank cuts the rate, variable-rate borrowers may see a reduction in their payments—unless the lender delays or withholds the adjustment.

While variable-rate mortgages track prime directly (e.g., “Prime - 0.90%”), fixed rates are affected more indirectly.

Step 2: Bond Yields and Fixed-Rate Pricing

Fixed-rate mortgages—especially the 5-year term, most common in Canada—are closely tied to 5-year Government of Canada bond yields.

Why bond yields matter:

• Lenders fund fixed mortgages by selling bonds or using funds benchmarked to bond performance.

• When bond yields rise, lenders’ cost of lending increases, and they raise fixed rates to protect profit margins.

• When yields drop, fixed rates generally follow—but with a lag or buffer.

Example:

If the 5-year bond yield increases from 3.30% to 3.75%, a lender may raise its 5-year fixed rate from 5.19% to 5.49%, depending on its spread targets and funding cost models.

Step 3: Lender’s Spread and Cost of Funds

Each lender layers on a spread over their funding cost. This spread reflects:

• Operational costs

• Targeted profit margins

• Risk appetite

• Market share strategies

Some lenders may tolerate lower margins to gain market share, offering aggressive promotional rates, while others price conservatively based on liquidity reserves or underwriting policies.

Step 4: Insurability and Risk Tiers

The mortgage's insurance status significantly affects pricing:

• Insured mortgages (less than 20% down, CMHC-backed): Lower risk to lenders → lowest rates

• Insurable mortgages (20%+ down, meets insurer criteria): Moderate risk → competitive rates

• Uninsured mortgages (20%+ down, does not meet criteria): Higher perceived risk → higher rates

Even with identical terms, an uninsured 5-year fixed mortgage may be priced 20–40 basis points higher than an insured equivalent.

Step 5: Borrower-Specific Pricing Adjustments

Individual borrower characteristics influence final pricing. Lenders assess:

• Credit score (typically above 680 for best pricing)

• Debt service ratios (GDS, TDS)

• Income consistency

• Loan purpose (purchase, refinance, transfer)

• Property type (condo, rental, single-family)

Example:
Two borrowers applying for identical 5-year fixed insured mortgages may receive different rates:

• Borrower A (credit score 780, salaried income, condo): 4.89%

• Borrower B (credit score 660, commission income, rental property): 5.24%

The Math Behind Prime-Based Pricing

For variable-rate mortgages, your pricing might look like this:

Quoted Rate = Prime – Discount
Example: Prime = 6.95%, Discount = 0.95% → Final Rate = 6.00%

Changes in the Bank of Canada’s rate cascade directly through this formula.

• If prime rises to 7.20%, new rate = 6.25%

• If prime drops to 6.70%, new rate = 5.75%

How Optimize Supports Rate Navigation

We help you:

• Understand the mechanics behind what lenders offer

• Model rate scenarios based on current bond yields and policy expectations

• Unpack loan structure risks, like IRD penalties and insurability pricing

• Compare rate offers not just by percentage, but by total cost, flexibility, and financial alignment