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Interest Rates 101

If you’re looking to buy a house, you’re probably listening to news about interest rates and how they’re changing.

To start with basics, interest is the amount you pay to borrow money. A higher interest rate may mean higher payments, or that it might take you longer to pay off a loan, as more of each installment (monthly or bi-weekly, usually) goes towards interest and less towards the principal (i.e. the money you borrowed).

Interest rates affect the housing market because they play an important role in determining the affordability of homes. Higher interest rates, effectively, makes the same priced home more expensive by increasing the money you will spend on your mortgage. This restricts the pool of potential buyers, limiting demand and cooling markets where prices are rising. Lower interest rates do the opposite. By lowering the cost of borrowing, you make homes more affordable, widening the pool of potential buyers and stimulating the market.

The Bank of Canada sets these interest rates as part of its economic policy depending on what is happening in the market. During COVID, for example, there was profound concern that the pandemic would bring spending to a halt, so the Bank responded by lowering interest rates to stimulate spending.

Now, two years later, the Bank is raising interest rates to slow inflation, as the price of homes and everyday goods begins to rise quicker than most Canadian’s can adapt to.

These hikes must happen slowly. If rates rise too drastically or suddenly, it could cause a sharp rise in payments for variable-rate mortgage holders and other borrowers, which means more people would default on their payments. If that happens in high enough numbers, it could cause significant problems for the broader economy.

Variable vs. Fixed Rate

When it comes to mortgage rates it’s important to shop around to ensure you’re comparing the best available rates.

Fixed rates tend to be higher—call it a premium for peace of mind. Once you’re locked into your mortgage with a fixed rate, you’ll be paying the same interest for the full course of the term (typically five years in Canada) at which point your mortgage rate will be adjusted. If rates go up during that term, you’re protected.

Variable rates tend to be lower, on average, than fixed rates. You can save huge amounts of money if interest drops because your rate will also drop. But you’re also exposed to more risk. If rates rise, as they are rising in the current market, so will yours.

Right now, about 80% of Canadian homeowners today opt for fixed rate mortgages but it’s important to look at long term-trends and evaluate your comfort level with risk. Talk to a mortgage specialist to better understand how changes to interest rates may affect your payments or the amount your eligible to borrow.

And remember it’s often not prudent to get a mortgage that puts a strain on your monthly expenses—even if you are approved for it. There are other costs of living besides your mortgage.

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