Why you should care about increasing mortgage rates

When you're planning to buy a home, starting with a budget is a good first step. That can help you figure out how much home you can afford and what you might need to save towards a down payment.

Mortgage interest rates are something else to consider along with other factors, the interest rate you pay for a mortgage can affect your monthly payment.

Rising mortgage rates could make homebuying more expensive. But the good news is that with the right planning, it’s still possible to afford the property you’re looking for.

How mortgage rates work

An interest rate represents the amount a lender charges someone for the privilege of borrowing money. Mortgage interest rates apply specifically to loans that are used to purchase property, including residential homes.

In Canada, mortgage interest rates are influenced by two distinct, but connected, factors: the overnight lending rate and the bond market. The overnight lending rate represents the interest rate at which banks lend money to one another. The Bank of Canada adjusts the target overnight lending rate on eight fixed dates each year.

Changes in the overnight lending rate can translate to shifts in the prime rate. Banks typically apply this rate when charging interest on variable-rate mortgages.

Meanwhile, bond markets are one of key factors that influence rates for fixed-rate mortgages. A bond represents a form of debt, funded by investors and repaid with interest. When bond yields move up or down, banks may adjust fixed mortgage rates accordingly.

So, what does all of that mean for you in simple terms? Just that mortgage rates are not fixed. They can go up, but they can also come back down. Keeping an eye on which way mortgage rates are trending is important if you’re planning to buy a home so you can estimate what you might pay.

What causes interest rates to rise?

The Bank of Canada uses short-term interest rates to influence monetary policy and to keep the economy running smoothly. When interest rates rise, it's usually done as a safety measure to keep the economy from overheating or as a defensive move against rising inflation.

When the economy's doing well, people tend to spend more money. If there's not enough supply to meet demand for goods and services, that can trigger a rise in prices. When consumer prices rise steadily over an extended period, that's called inflation.

Inflation can affect people in different ways depending on their situation. So, what does that have to do with interest rates and, more specifically, mortgage rates? Simply that when inflation exceeds the target levels, the Bank of Canada can raise the overnight lending rate to try and quell rising prices.

What happens when interest rates rise?

The most immediate effect of rising interest rates is an increase in the cost of borrowing money. When it costs more to borrow money, you might be tempted to curb spending. As consumers spend less, that can ease demand for goods and theoretically drive prices back down.

This is how the Bank of Canada uses interest rates to try and manage monetary policy through periods of inflation. The interest rate policy works in reverse when they want to stimulate the economy, meaning that rates may be cut to make borrowing more accessible and encourage spending.

An indirect side effect of an increase in the overnight lending rate is that mortgage rates increase as well. That means that if you're on the hunt for a first home (or your next one), you may see higher mortgage rates. On the upside, housing prices tend to drop and you’ll see some more affordable options on the market. You might also see less competition for homes if there are fewer buyers in the market, which is good thing if you’re worried about getting caught in a bidding war.

Buying a home when mortgage rates increase

If you're ready to become a homeowner, it's important to understand what rising interest rates could mean for you. The higher your mortgage rate, the higher your monthly payment is likely to be and the more you'll pay in interest over the life of the mortgage.

Fortunately, there are some things you can do prepare yourself financially so that you’re in the strongest position possible to buy.

• Pay down existing debt. If you anticipate a slightly higher mortgage payment because interest rates are higher, you can create some breathing room in your budget by eliminating other debts. Getting rid of high-interest credit card balances can be a smart move, as they might be costing you more in interest than student loans or an auto loan.
• Check your credit. Credit scores carry significant weight in mortgage lending decisions and the higher your score, the better your odds of getting approved for lower mortgage rates. Reviewing your credit reports for errors – and disputing any you find – could give your score a positive boost.
• Increase your down payment. The more you put down on a home, the less you’ll have to finance with a mortgage. So, if you’re aiming to save 10% down, for example, you might consider bumping that up to 15% or 20% instead to help reduce monthly mortgage costs.

So, when is a good time to buy (or sell) a home during a period of rising interest rates? If you're a buyer, it’s a good idea to fill out a pre-qualification application to find what rates you qualify for. That way, you’ll be able to assess your options. This first step can help you lock in a lower, preferred rate for a mortgage before it increases. Understanding what a variable or fixed-rate mortgage is will help you determine what the best option is for you.

If you’re planning to stay in your home for a while, you’ll be less likely to worry about the impact of rising rates. Since these price changes are cyclical, this means that in the long run, you’ll be able to benefit from the equity that you can then build in your home.

If you're selling a home, you may have to consider how easy it'll be to find a qualified buyer during a time with possible housing price drops and rising rates. And if you're planning to use the proceeds from the sale to buy another home, you'll also have to think about what you'll be able to afford if rates are higher.

Will interest rates rise again?

The general answer is yes, interest rates may rise again but they'll also fall again. That's in keeping with how the business cycle works. If you're not familiar with the business cycle, it just means how the economy moves through different phases.

You have a period of expansion in which the economy grows. Interest rates might be low during this time, so consumers spend more. Eventually, this period of expansion hits a peak. This is when the Bank of Canada may step in and raise rates if the economy is growing too rapidly.

After a peak, you get a period of contraction in which the economy shrinks. People borrow less and spend less. This eventually leads to a trough where economic activity is at its lowest. The Bank of Canada may cut rates to boost spending and borrowing, which then leads to the beginning of the next expansion phase. The cycle repeats over and over, with rates moving up or down at different times.

The bottom line

Regardless of what's happening with interest rates, it's helpful to talk to a mortgage professional. A BMO mortgage specialist can review your home loan options to help you find a mortgage that fits your budget. You can also compare mortgage rates online to help decide if a variable or fixed-rate mortgage makes more sense for you. Remember, BMO offers a 130-day mortgage rate guarantee for fixed rate mortgages. By locking your rate today, you won’t be impacted if rates rise tomorrow.