Interest Rates in Canada: What Homebuyers Should Know

Everyone who buys or builds a home in Canada needs to know about interest rates. They make a HUGE difference in what you can afford and how much you'll pay over time.

You can think interest rates as the cost of borrowing money. When they're high, it costs more to get a loan. When they're low, you pay less. But there's a lot more nuance you need to understand. Let's look at what this means for you and how to make smart choices when shopping for a mortgage loan.

Quick Tips About Interest Rates

• The interest rate applied to your mortgage is based off the Bank of Canada interest rates.
• Interest applied to a loan means you may pay back a higher amount than what you borrowed. With property appreciation or rental income, you can break even or earn a profit.
• Fixed rates keep your payments the same; variable rates might save money but can change monthly
• The central bank's decisions directly affect your mortgage rates
• Your principal amount × interest rate determines your interest payments applied to your monthly mortgage

What Are Interest Rates?

An interest rate is simply what lenders charge you to borrow money. Think of it as the "rental fee" for using the bank's money to buy your home. The percentage rate shows how much extra you pay when taking out a home-buying loan.

In Canada, you'll choose between a fixed interest rate (same payment for years) or variable rate (payments that change with the market).

As of 2024, higher interest rates have changed what many buyers can afford. A home that was in your budget last year might be out of reach today. When borrower pays more interest, their buying power drops significantly.

How Are Interest Rates Determined in Canada?

The Bank of Canada pulls the strings when it comes to interest rates. They set something called the "overnight rate" which affects all other rates.

The Bank watches inflation closely. When prices rise too fast across the country, they often raise rates to control inflation and limiting spending. Conversely, they'll lower interest rates if the economy gets too slow and needs more activity.

Other factors that change your mortgage interest rate:

• How strong the economy is
• Job numbers and growth reports
• Market forces like supply and demand for loans
• Your personal credit score and financial situation

Commercial banks then take all this information and set their lending rate based on what's happening in global, national, and local economies. These financial institutions adjust their rates to reflect both the central bank's decisions and their own profit needs.

Why Interest Rates Matter When Buying a Home

Higher interest rates hit your wallet in very real ways:

• Your monthly interest payments go up
• The total house price you can afford goes down
• You'll pay more total interest over the life of your loan

Let's put this in real numbers. For every 1% increase in interest rates, your buying power drops about 10-15%. The principal × interest rate calculation directly affects how much house you can afford.

Say you qualified for a $500,000 mortgage loan when rates were 3%. If rates jumped to 4%, you might only qualify for about $450,000 because the necesarry monthly payments would be higher. This is how interest rates directly affect your personal finance decisions.

This means you might need to look at smaller homes or more affordable neighbourhoods than you originally planned. Your loan agreement stipulates exactly how much interest you'll pay over time, so even small rate differences add up to a lot more money over 25 years.

Simple Interest vs. Compound Interest: How They Work

Simple interest is calculated only on the principal amount you borrowed. This straightforward calculation applies the interest rate just to your original loan.

Compound interest is calculated on both your original principal amount AND any accumulated interest that builds up over time.

Most mortgages use compound interest, which means you pay interest on interest. This makes your total interest much higher than you might expect.

The good news? Making extra payments directly cuts your principal amount and reduces the compounding effect over time. This strategy can save you thousands in interest paid over the life of your mortgage.

Types of Interest Rates for Home Buyers

Fixed Rate: Steady and Predictable

A fixed rate doesn't change during your mortgage term. Your payment stays exactly the same month after month.

Most Canadians choose fixed rate mortgages for 5 years, but you can get terms from 1 to 10 years. This fixed income approach to lending helps you plan your budget with certainty.

The big advantage? No surprises. You know exactly what you'll pay every month, making budgeting much easier.

Fixed rates work well if you:

• Need stable payments for budgeting
• Think rates might go up soon
• Plan to stay in your home for several years
• Want to sleep better at night without worrying about rate changes

With a fixed rate, your loan agreement clearly shows the interest charged for the entire term, giving you peace of mind.

Variable Interest Rates: Lower But Riskier

A variable interest rate can change throughout your mortgage term. When the Central Bank moves its rates, your mortgage rate moves too.

Typically, you'll start with a lower rate that fluctuates over time. This lower starting interest rate can mean significant savings compared to the static nature of a fixed interest rate.

The main appeal? They often start lower than fixed rates, which means smaller payments at first and potentially big savings if rates drop.

Variable rates might be right if you:

• Are comfortable with some risk
• Have room in your budget if payments increase
• Think rates might go down in the future
• Want the lowest possible starting rate

With a variable interest rate, your interest paid will change based on market conditions in previous periods, which some buyers find worth the potential savings. You also may be able to refiance your home loan for better terms.

How Much Will You Actually Pay? Learn What Goes In Your Mortgage

That interest rate the lender quotes isn't telling you the whole story. Learning what's in your montly mortgage payment as well as the differences between the advertised rate, APR, and APY will put you ahead of the curve.

Lenders don't always make these numbers easy to understand. They might show you the lowest possible number to get you in the door. Let's clear up the confusion so you can spot the best deal.

What's Actually in Your Monthly Payment?

When you see a mortgage rate advertised, that's just the basic interest rate. But your true cost includes more than that.

Your mortgage payment has four main parts:

• Principal (paying back what you borrowed)
• Interest (what the lender charges you to borrow)
• Taxes (property taxes for your home)
• Insurance (homeowners insurance or condo insurance)

So a simple formula would look like this: Monthly mortgage amount = principal x interest rate + taxes + insurance

APR: The "Real" Cost of Your Loan

APR stands for Annual Percentage Rate. Think of it as the "all-in" rate that includes:

• The basic interest rate
• Closing costs
• Loan origination fees
• Mortgage insurance
• Other lender charges

Even if two loans have the same interest rate, the one with the higher APR is more expensive over time because of higher fees. It helps you compare loans more accurately than just looking at interest rates.

APY: How Interest Grows Over Time

APY stands for Annual Percentage Yield. This number shows what happens when interest compounds - meaning you pay interest on previous interest.

With mortgages, APY matters most when you're looking at:

• Adjustable-rate mortgages (ARMs)
• Home equity lines of credit (HELOCs)
• Savings accounts for your down payment

Basically, APY is what you earn from interest and APR is what you owe from interest.

Using Interest Rates to Save Money

Smart Canadian homebuyers can use interest rates to their advantage:

• Lower interest rate = lower payments = more savings potential
• Government programs help you build wealth and invest money for housing
• Understanding how principal × interest rate calculations work helps you make better decisions

Canadian Savings Programs That Can Help

1. First Home Savings Account (FHSA): Save up to $40,000 tax-free specifically for your first home. Contributions are tax-deductible AND withdrawals to buy a home are tax-free. Win-win!
2. Tax-Free Savings Account (TFSA): Any interest earned grows completely tax-free. Use this for your down payment savings to avoid taxes on your earnings.
3. Registered Retirement Savings Plan (RRSP): First-time buyers can borrow up to $35,000 from their RRSP tax-free for a down payment (but you must pay it back).
4. Registered Education Savings Plan (RESP): While meant for education, this can indirectly help by covering education costs so you can put more toward housing.
5. Registered Disability Savings Plan (RDSP): Offers grants and bonds along with tax-deferred growth for those who qualify.

These programs let you deposit money and watch your savings grow through compound interest while offering tax advantages. Unlike personal loans that require interest payments, these savings accounts actually earn interest at a savings rate determined by your financial institution. The interest rate refers to what you earn rather than what you pay.

Bottom Line: Stay Informed About Rates

Interest rates can make or break your home buying experience. Even small changes can mean thousands in more money paid over your mortgage.

Keep these key points in mind:

• Higher rates mean less buying power in the housing market
• Fixed rate gives stability, variable rate offers potential savings
• The central bank's decisions directly impact your mortgage interest rate
• One year lending agreement terms are available if you're uncertain about future rates
• Government savings programs can help offset higher rates

The stock market and bond prices also respond to interest rate changes, which can affect your overall investment strategy while saving for a home.

By understanding how interest rates work, you'll make better decisions about when to buy and what mortgage option fits your situation best.