What Drives Variable Rate Mortgages?

My previous blog post discussed factors driving fixed rate mortgages.  What about variable rate mortgages? Variable mortgages are driven by prime rate (which is based on Bank of Canada's benchmark rate) and the discount a lender would provide. For example, 5 year variable mortgage at prime less 0.75%.

The benchmark rate, is set by the Bank of Canada on eight set dates annually.  Bank of Canada targets inflation around the 2% level, if inflation is higher then the benchmark rate is increased to control inflation and in cases where there is low inflation (or deflation), the benchmark rate is lowered to stimulate consumer spending and business investments due to the low cost of borrowing.

What does the dollar have to do with prime rate?


Canada's benchmark rate cannot be at a much higher level than the US benchmark rate since a substantial difference between the two would drive foreign investors to buy the Canadian dollar and appreciate its value.  A stronger Canadian dollar would reduce Canada's competitiveness by making Canadian products more expensive therefore reducing exports and slowing economic growth.  The US economy has and will continue to experience tough and slow economic recovery. The US Federal Reserve will keep its benchmark rate low to stimulate the economy, create jobs, promote consumer spending and increase housing demand through low interest rate environment.  With the upcoming US elections in 2012, the US will keep rates low to aid re-electing the current president (historic data shows in re-election years US interest rates are kept low).  This low US interest rate environment will exert more pressure on the Bank of Canada not to increase the Canadian benchmark rate aggressively till the end of 2012 which makes variable interest rates favourable. Having said that, the Bank of Canada will have to increase the benchmark rate to control inflation and high consumer debt levels, however it will be gradual. My prediction is 0.5% increase for this year.

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