Whenever making a large purchase – and there are few larger purchases than real estate – it is essential to understand the full scope of your expense. That’s why it is so important to have a strong understanding of interest rates and what they mean for your pocketbook.

Purchasing real estate requires borrowing a large sum of money – usually from a bank in the form of a mortgage – in order to facilitate the transaction. To provide lenders an incentive for lending out their money, interest rates are charged, by the lender to the borrower. The borrower, in turn, agrees to pay back the lender the original borrowed sum (referred to as the principle), plus an additional percentage (referred to as the interest), within an agreed-upon timeframe. Typically the interest rate is expressed as an annual figure over a defined period of time.

For example, say that two hypothetical best friends, Mr. X and Ms. Y each look to purchase a property in the same building in Toronto for $500,000.

Despite being best friends, Mr. X and Ms. Y were born several years apart, and as a result hit certain milestones in life, such as purchasing their first property, at different times.

Both prudent savers, neither Mr. X, nor Ms. Y wants to over-leverage themselves, so they both wait until they have $100,000 saved up to ensure a 20% downpayment on their $500,000 properties, (a 20% downpayment this ensures that they don’t need to make any additional monthly payments for CMHC Mortgage Insurance).

The older of the two friends, Ms. Y was able to take out a 5-year fixed rate mortgage at an interest rate of 4.66% in 2016, while Mr. X was ready two years later and took out a 5-year fixed rate mortgage at an interest rate of 5.27% in 2018.

How do interest rates impact the amount you end up paying on a mortgage?

Now, both Ms. Y and Mr. X have each borrowed $400,000 toward their purchase. Both have chosen 5-year fixed rate mortgages, meaning that they have locked in the interest rate they are obligated to repay on the principle of their loan at 4.66% and 5.27%. Despite the similarities in their positions, due to a .71% higher interest rate on his loan, Mr. X will end up paying nearly $7,000 more than Ms. Y over the course of their amortization periods.

As illustrated by our above example, understanding the implications of the interest rate at which you are able to borrow money is key to healthy finances. As the sums with which real estate transactions are carried out tend to run from the hundreds of thousands, to the millions of dollars, the difference of a few percentage points in interest rates can result in many thousands of dollars more, or less, paid back over the course of the duration of the loan.

How are interest rates determined?

In Canada, interest rates for lending are determined by a variety of factors, including aggregate demand for loans throughout the country, the available supply of capital to be leant, inflation rates, interest rates in the United States, and, the policy of the Bank of Canada, amongst others. However, it is primarily the Bank of Canada who is charged with setting interest rates for Canadian borrowers by setting the prime rates at which the banks are themselves able to borrow capital to facilitate lending operates, such as mortgages.

Today, the Bank of Canada’s prime rate is an unusually low 2.45%, which means that if you are able to, it’s a very attractive time for borrowers to take on large amounts of debt and low-interest rates. While an excellent time for those of means to snap up property using cheaply borrowed money, we at Key recognize that this system of facilitating homeownership is broken due to its inaccessibility to the vast majority of Canadians who have difficulty saving up the required amount for a down payment.

That’s why at Key we’ve flipped the model on its’ head, removing the need completely to take on the burden of a mortgage.