How do interest rates affect my mortage?

Buying a home is a big deal. In fact, it’s likely to be a person’s biggest purchase.

That’s why mortgage loans exist. With a home purchase often costing several hundred thousand dollars, these loans allow people to buy homes sooner, rather than saving up for years or decades.

But before you sign a loan contract, it’s important to fully grasp how interest rates can affect a mortgage, because the impacts can be quite significant. Interest rates can sway how much money a borrower will pay over the loan’s lifetime, how much the monthly payments will be, and more.

What is a mortgage interest rate?

Practically any loan, whether it’s for a car, kitchen renovation, or home purchase, will come with an interest rate. Think of a loan’s interest rate as the fee paid for borrowing money from a lender. After all, lenders have to make a profit for letting people borrow money in the first place.

A mortgage interest rate is calculated as a percentage of the total asking price for a home. Each month, that percentage is added on top of the total loan amount.

For example, say that someone—let’s call her Alice—is ready to buy her first home and takes out a mortgage loan for $300,000. She makes a down payment of $30,000, making the remaining balance $270,000. The loan’s interest rate is 3.99% and the loan term is 30 years (i.e. Alice will pay the loan off over 30 years with regular monthly payments). Each month, Alice pays off a proportion of the total remaining asking price, or $270,000. Take 270,000 divided by 30 x 12 (30 years with 12 months each) to get $750 for the basic or principal monthly payment — not too bad!

"Think of a loan’s interest rate as the fee paid for borrowing money from a lender. After all, lenders have to make a profit for letting people borrow money in the first place."

However, Alice still needs to consider that the loan will add another 3.99% on top of the existing remaining balance each month. The longer the loan goes, the more money Alice will end up paying in the long run.

Now, Alice has to take the 3.99% (or 0.0399) and divide it by 12, which would total to 0.003325. Multiply the loan balance of $270,000 by 0.003325, and her monthly interest in dollar value becomes $897.75.

As seen above, this hypothetical mortgage loan’s first monthly interest payment is actually larger than the principal payment for the loan. This is not uncommon with mortgages.

However, as time goes on, the principle of the loan decreases, so interest payments would as well. Near the end of the mortgage loan’s term, the majority of each monthly payment will be for the principal, not the interest.

Most people take out mortgage loans because it’s just too expensive to purchase a home outright these days. And in some cases, many mortgages are cheaper than rental costs, even after factoring in the interest rate.

How do lenders calculate mortgage interest rates?

Mortgage loan lenders don’t give everyone the exact same mortgage interest rate. Instead, they calculate unique mortgage interest rates for each loan they draw up based on several important factors.

1. The Bank of Canada’s interest rate

All loans initially come from the Canadian government. The Bank of Canada is in charge of the nation’s funds, so they loan money to the big banks and lending institutions that, in turn, lend money to a prospective homeowner.

The Bank of Canada sets the default interest rate for all the loans that it gives out, which affects the interest rates that lenders have to set so they can make a profit and stay in business. Occasionally, the Bank of Canada may raise or lower the general interest rate to prevent inflation, which may impact a mortgage’s interest rate as well.

2. The prime rate

Lenders also use a factor called the prime rate to calculate mortgage loan interest. The prime rate is a special interest rate that most commercial banks charge for their creditworthy or big corporate customers, like mortgage loan lenders.

Just like with the interest rates set by the Bank of Canada, the prime rate can influence the interest rates that lenders are comfortable assigning to new mortgage loans.

3. Credit score

It’s well known that credit score is a super important financial metric. The higher a credit score is, the more creditworthy a borrower appears to be, and the more comfortable lenders will feel when offering favourable loans.

People can build their credit history by being punctual with their debt repayments, paying bills on time, and refraining from unnecessarily risky credit. If you want to take things up a notch, you can look into KOHO’s Credit Building tool which, for $7 a month, will help build your credit history in just six months.

4. Down payment (loan-to-value ratio)

A mortgage loan’s interest rate is calculated based on the remaining cost of a new house after a down payment. Let’s bring back Alice to visualize this. If she pays $30,000 in the above-mentioned $300,000 hypothetical house, she’ll only have $270,000 remaining to pay off. The interest rate will be calculated based on the $270,000, not the $300,000.

This can also be called the “loan-to-value” ratio.

5. Loan term

The loan term is how long the loan is expected to last, usually denoted in months. A longer term means a buyer will make smaller monthly repayments, whereas a shorter term means that buyer will have to make larger payments every month.

Mortgage loan lenders will adjust the interest rates accordingly based on a loan’s term.

6. Overall perceived risk

Above all else, lenders look at the overall perceived risk of a potential borrower and their desired home. If they think it's a low-risk loan – perhaps for a newly built home that will likely not require lots of repairs, to someone with a high credit score – they won't charge an exorbitant interest rate.

The reverse is true if the bank or lender concludes it’d be risky to give a potential borrower a mortgage loan. They’ll saddle said borrower with a high interest rate so they can get as much money as possible in the event that they default.

Do mortgage interest rates change?

Absolutely, which only makes things more confusing for regular home buyers – but don’t groan just yet.

Interest rates on a mortgage will only change about once every five years, typically when the mortgage contract is required to be renegotiated, or if the mortgage owner requests a renegotiation for events like refinancing their home. Most mortgage loans have variable interest rates, which mean that they can shift or fluctuate over time.

A lender could lower a loan’s interest rate if the borrower’s credit score has improved since their last renegotiation or the Bank of Canada has lowered the national interest rate. Of course, said borrower might also get unlucky and have a higher interest rate the next time it changes.

Fixed vs variable interest rates

Some mortgage lenders will allow homeowners to choose a fixed interest rate instead of a default variable interest rate. A fixed interest rate is, as the name suggests, an interest rate that does not change with time, even if the economy sees large-scale changes, like the Bank of Canada changing the national interest rate.

However, fixed interest rates are usually a little higher than the low rates seen with variable options. Consider all the options carefully before signing on the dotted line since both fixed and variable interest rates have advantages.

"The higher a credit score is, the more creditworthy a borrower appears to be, and the more comfortable lenders will feel when offering favorable loans."

How do I know whether a mortgage’s interest rate is worthwhile?

Naturally, lower mortgage interest rates are typically better if they’re available. However, there are various aspects that can determine whether a loan is worthwhile. For example, there might be an excellent mortgage loan available with a low interest rate, but it may have a short term of 15 years.

That means a borrower will have to pay off the loan much more quickly and in larger monthly payments. In this case, it might be cheaper or more affordable for a homeowner in the short term to take out a loan with a higher interest rate and a longer term.

Ultimately, the best way to determine whether a mortgage’s interest rate is worthwhile is to look at all your finances, determine what monthly rate you can afford, and all terms and conditions. Don’t just go with the mortgage that’s cheapest at first glance.

How to get a better mortgage interest rate

When choosing a variable mortgage interest rate option, there are ways to lock in a better interest rate over time, or to get better interest rates for future loan applications.

1. Improve your credit score

For starters, you can build your credit history by:

• Paying down any existing debts

• Not opening unnecessary lines of credit

• Hiring credit repair services to help fix negative line items on a credit report

• Using a credit building tool like KOHO’s

A higher credit score means a bank or lender is more likely to give a borrower a loan with a low interest rate.

2. Wait for interest rates to drop

On the other hand, a prospective homebuyer can hold off on their purchase until the Bank of Canada lowers national interest rates, because mortgage loan interest rates will be sure to follow. But this option is contingent on being able to wait for up to several years and read the market to predict when an interest rate dip is imminent.

3. Make a bigger down payment

Remember, a mortgage loan’s interest rate is based on the remaining total of a home purchase cost. Make a bigger down payment, and you’ll find yourself a smaller percentage-based interest rate.

It’s all in the details

All in all, interest rates play a huge role in whether a certain mortgage loan is a good choice overall, whether a particular house is affordable, and whether the monthly payments will be manageable over the long-term.

Consider all options carefully and be sure to read all the specifics of a loan’s interest rate before signing to maximize the chances of getting a flexible, easy-to-pay mortgage for a new home!