Bond yields play a pivotal role in the financial world, influencing various aspects of the economy, including fixed-term mortgage rates. In this article, we will delve into how changes in bond yields can affect the rates homeowners pay on their mortgages. 

What are bond yields?

Bond yields, often referred to as bond interest rates or bond coupon rates, are the returns you get for a bond over a specific period of time. 

Bonds are traded in a public market, which means they can drop at a higher or lower price than their original face value. 

What drives up bond yields?

Bond yields rise and fluctuate based on changing economic environments. The factors fueling this bond market spectacle are as diverse as they are influential. Here are some key drivers: 

Competing investments: When five-year government bond yields rise, they become more attractive to investors seeking stable, low-risk returns. This can lead to increased demand for bonds, potentially affecting mortgage rates as lenders adjust to stay competitive. 

Economic indicators: Changes in the yield of five-year government bonds can reflect broader economic conditions.  For example, if rising yields are driven by expectations of higher economic growth and inflation, lenders may raise mortgage rates to account for the increased risk associated with inflation, which erodes the value of the fixed interest payments they receive from borrowers. 

Central bank policies: When the Bank of Canada (BoC) raises short-term interest rates, it has a ripple effect on the yield curve, impacting various bonds, including five-year government bonds. This, in turn, can influence the pricing of fixed-term mortgages during signings or renewal. 

How do bond yields affect mortgage rates?

In Canada, fixed mortgage rates are directly affected by bond yields whereas variable mortgage rates are affected by the overnight rate set by the BoC. Any movements to bond yields are reflected by fixed-term mortgage rates. When bond yields go up, fixed mortgage rates also go up. 

Five-year fixed mortgages

The yield on a five-year government bond is often used as a benchmark by lenders when setting the interest rates for five-year fixed-term mortgages. Lenders typically add a margin or spread to the five-year government bond yield to determine the mortgage rate they offer to borrowers. If the five-year government bond yield increases, lenders raise their mortgage rates accordingly to maintain their profit margins. 

The spread between bond yields and fixed-mortgage rates

Government bonds are relatively risk-free, but mortgage rates are not. To balance this risk, mortgage rates have a risk premium added above bond yields to ensure costs in a moving market are being covered. This means, if the 5-year Government of Canada bond yield goes up 100 basis points (bps), fixed mortgage rates may go up about 200-300 bps because of securitization. 

The equation is as follows:

How do rising interest rates affect bond yields?

The primary tool that the Bank of Canada uses to influence the overall interest rate climate is the overnight lending rate, also known as the policy rate. This rate represents the cost at which financial institutions can borrow funds overnight from the central bank.  

When interest rates go up, newer bonds become more attractive than older ones. As a result, existing bonds lose value and have to be sold for less. 

As bonds become cheaper, they need to offer higher yields to stay attractive to investors. This increase in bond yields can impact both variable and fixed mortgage rates in Canada.  

Impact on variable mortgage rates

Direct correlation: Variable mortgage rates in Canada are closely linked to short-term interest rates, which are directly influenced by the central bank's policy rate. When the central bank raises its policy rate, financial institutions increase their prime lending rates, which, in turn, affects the interest rates on variable-rate mortgages. 

Immediate increase in mortgage rate: Unlike fixed-term mortgage rates, variable mortgage rates adjust quickly in response to changes in the central bank's policy rate. This means that when the central bank hikes rates, borrowers with variable-rate mortgages will see an immediate increase in their monthly mortgage payments. 

History vs. present: Consider historical data on mortgage rates, which typically favors variable rates. The current data shows that since March 2022, after ten BoC rate hikes, an estimate of 50% of variable-rate mortgage holders have surpassed their trigger rates - representing about 13% of all mortgages. 

Impact on fixed mortgage rates

Link to bond yields: When the central bank raises its policy rate, it often results in an upward shift in bond yields across the yield curve, including the yields on longer-term government bonds. This, in turn, puts upward pressure on fixed-term mortgage rates. 

Cost of borrowing: For Canadian homebuyers seeking stability and predictability with their monthly payments, fixed-term mortgages are a popular choice. When bond yields rise due to central bank rate hikes, lenders may increase the interest rates they offer on fixed-term mortgages to maintain their profit margins. As a result, borrowers may face higher borrowing costs. 

As a borrower, you need to consider your risk tolerance and financial circumstances when choosing between fixed and variable mortgage products, as the impact of central bank rate changes can differ between these two options. 

Read more: The rate debate: should you with a fixed or variable mortgage? 

Inflation rates expected to be higher for longer

Inflation and interest rates are expected to be higher for longer – raising the odds of another Bank of Canada rate hike in October despite its last policy pause. According to a recent Bloomberg survey of economists, the central bank is assumed to start rate cuts only once in the first half of next year. 

The 5-year government bond reached a maximum yield of 4.46 per cent on October 3, and hasn't been this high since the early 2000s. This relentless rise since 2021 has been causing a lot of anxiety for those renewing their mortgages. Canadian mortgage borrowers saw their interest costs climb in the second quarter, surging by more than 80% since the initiation of interest rate hikes by the Bank of Canada. 

What it means for potential homebuyers

High inflation, increasing interest rates, and a slowdown in the housing market nationwide have taken a toll on consumer confidence. As a result, there’s a reduced number of prospective homebuyers, leading to a decline in the growth rate of mortgages in Canada. 

“Affordability is incredibly difficult right now and a certain income today can only qualify for 78 per cent of what they could qualify for just one year ago,” explains Eitan Pinsky, mortgage expert and owner of Pinsky Mortgages. “Second, many buyers are thinking that prices will decrease, and they’re unwilling to purchase at this time of such high real estate prices and interest rates. My realtors are reporting that even though buyers are unwilling to purchase at high prices, sellers are also unwilling to lower their prices. Many homes are sitting right now.”

Related: What does it mean to be house poor? 

What it means for homeowners

Any changes in bond yield or BoC overnight rates won’t impact homeowners locked in a fixed-year mortgage term. It only affects you during renewals based on the market.  

If you’re not due for a mortgage renewal immediately, it may be wise to reach out to a mortgage broker or financial planner to see what a potential rate increase would do to your current mortgage payment. 

Prepping to avoid payment shocks

Mortgage payments are predicted to rise between 20 per cent to 25 per cent in 2025 and 2026. For a homeowner with a mortgage, the worst scenario is experiencing payment shock. Payment shock is when your monthly mortgage payment unexpectedly changes drastically.  

“You can start by putting away money for savings per month, then increase the monthly amount you put aside over the course of a year or two to be ready to pay that extra amount,” says Pinsky. “By building small and increasing to what’s required, it gets rid of payment shock.” 

Related: Historical mortgage rates: averages and trends from the 1970s to 2021

What if you’re renewing your mortgage?

Bond yields on the rise have set the stage for a financial narrative that's of crucial interest to mortgage holders. 70 per cent of Canadian homeowners buying or renewing their mortgage in the next year are concerned about qualifying. Renewing your mortgage is a major financial decision in today’s financial climate. Here are some ways to combat against rising mortgage rates if you’re due for a renewal: 

Accelerate your payments: Some mortgage agreements allow you to increase your regular payments or make additional payments toward your principal without penalties. This can help you pay off your mortgage faster and save on interest. 

Lump sum payments: If you come into a lump sum of money, such as a bonus or inheritance, consider making a lump sum payment toward your mortgage principal. This can reduce your outstanding balance and save you on interest costs, being your saving grace with interest rates at an all-time high. 

Mortgage term extension: Extend your current mortgage term beyond its original expiry date to maintain your current interest rate and avoid higher rates. However, it can extend the total time it takes to pay off your mortgage, increasing the overall interest cost. 

Leverage your position: When renewing your mortgage, don't hesitate to negotiate with your lender for better terms, rates, or conditions. Lenders may be willing to accommodate your requests, especially if you have a strong payment history. 

Stretch your amortization period: Extending the amortization period can lower your monthly payments, providing short-term relief. However, this may result in paying more interest over the life of your mortgage, so weigh the pros and cons carefully. 

Consider an early renewal: Despite the Bank of Canada's rate hike pause, rising bond yields point to a probable rate increase in October. Acting now, even if the early renewal rate is slightly higher, can protect you from steeper rates later. Consider securing a more favorable rate before the next hike. 

Shop for rates and lenders: Shopping around and comparing offers from different lenders can help you secure a more competitive mortgage rate, saving you money over the term of your mortgage. However, be prepared to meet mortgage approval requirements, including passing the stress test with interest rates rising, providing credit checks, and proof of income. There may be more resistance in getting your mortgage approved now than it was when you first bought your property. 

Refinance your mortgage: If you’ve lost your primary source of income or your financial situation and goals have changed since your last mortgage term, you may want to consider refinancing. This could involve adjusting the term, interest rate, or even borrowing additional funds for home improvements or debt consolidation. 

“It’s important to note that whenever you renew your mortgage, it's based on the current outstanding amortization period which would mean higher payments if interest rates were higher,” says Pinsky. “However, if you refinance your mortgage, particularly if you switch from a longer term (20 years or 30 years) to a shorter one, your payments could decrease. This refinance might be the right choice for those who need lower payments. But this requires a new application and approval process.”    

Read more: What to do if your mortgage loan application is denied

Does mortgage term length matter?

For you and most Canadians, affordability may be your primary priority right now. The change in markets might be putting you in a spot where allocating money towards your principal has taken a back seat, and what’s driving your finances is making ends meet.  

If Bank of Canada decides to resume raising interest rates, a move that appears likely given the rising bond yields, opting for fixed-term mortgages could potentially offer a more secure financial position. 

When choosing between a 5-year or 3-year fixed-rate mortgage in Canada, several factors come into play: 

Market outlook: Consider the current and projected market conditions. If interest rates are expected to rise, a 5-year term can provide stability and shield you from potentially higher rates down the road. Conversely, if rates are predicted to fall, a 3-year term may be more advantageous to secure a lower rate later. 

Risk tolerance: Ask yourself how comfortable you are with the possibility of higher interest costs for longer. If you want to play it safe, a 5-year fixed-rate mortgage makes sense. Fixed-rate mortgages maintain a constant interest rate throughout the term, ensuring predictable payments.   

Long-term plans: Your housing plans matter too. If you plan to keep your property for 5 years or more, a longer term reduces the need for frequent rate negotiations. However, if you anticipate selling within 3 years, a shorter term minimizes the penalty for early mortgage discharge – otherwise resulting in an interest differential fee. 

Advantages and disadvantages: Shorter-term mortgages often have lower interest rates and penalties for early termination but expose you to market fluctuations and more frequent rate renegotiations. Longer-term mortgages provide stability but may come with higher rates and potential lock-ins if rates drop. 

“At this time, longer-term rates are cheaper, and it could mean that a client can qualify for a higher mortgage amount. Longer term mortgages might also be worth considering if you want to avoid frequent renewals for the long haul as they’re more of a peace of mind.” explains Pinsky. But most importantly, “It pays to have choice – don’t exclusively go to your bank to get an opinion.”  

It’s important to browse the best rates and find what’s best for your financial situation. 

Ultimately, your choice between a 3-year and 5-year fixed-rate mortgage depends on your outlook for interest rates, housing plans, risk tolerance, and preference for payment stability. Consider opting for a 5-year term for stability, or go with a 3-year term for flexibility and the chance to capitalize on lower interest rates sooner.  

Read next: What’s a mortgage default, and how do you avoid it?