The Credit Spread: The Invisible Margin That Determines Your Rate
When a lender quotes a fixed mortgage rate, that rate comprises two distinct components: the Government of Canada bond yield serving as the reference and the lender's credit spread. If the 5-year bond yield is 3.50% and the offered fixed rate is 5.20%, the credit spread is 1.70%. This margin varies from lender to lender, product to product, and fluctuates over time based on market conditions. For mortgage brokers, understanding this breakdown is essential for analyzing offer competitiveness and negotiating effectively.
- Mortgage credit spread
- The gap between the fixed mortgage rate offered by a lender and the Government of Canada bond yield of the same maturity. It represents the risk premium, operational costs, and lender's profit margin. The narrower the spread, the more competitive the offered rate.
Components of the Credit Spread
- Default risk: probability the borrower will not repay. This risk is considerably mitigated by mortgage insurance (CMHC, Sagen, Canada Guaranty) for loans with less than 20% down, explaining the lower spread on insured loans.
- Operational costs: loan administration, file origination, customer service, regulatory compliance, and technology infrastructure. These costs are relatively fixed and represent approximately 0.30% to 0.50% of the spread.
- Prepayment risk: if the borrower repays before maturity (sale, refinance), the lender loses future interest income. The lender protects itself through prepayment penalties and a spread component.
- Lender funding costs: the bank itself must borrow or mobilize deposits to fund mortgages. The excess cost relative to government bonds is included in the spread.
- Profit margin: the lender's profit on the mortgage product, variable based on commercial strategy and market competition level.
Mortgage Insurance's Influence on the Spread
Insured loans (down payment under 20%) benefit from a significantly lower spread than conventional loans (20% or more down). The reason is straightforward: for an insured loan, default risk is transferred to the mortgage insurer (CMHC, Sagen, or Canada Guaranty), eliminating the 'default risk' component of the spread. This is why a borrower putting 5% down can paradoxically get a fixed rate 0.10% to 0.30% lower than one putting 20% down. Brokers should explain this paradox to clients and analyze whether the insurance premium cost is offset by rate savings. In many cases, the insured loan is less costly overall despite the insurance premium.
Factors Causing Spread Variation Over Time
The credit spread is dynamic and fluctuates based on several macroeconomic and microeconomic factors. Competition among lenders is a major factor: when banks battle for market share (typically in spring, the peak real estate season), spreads compress. Financial market liquidity conditions affect banks' funding costs and therefore their spread. OSFI capital requirements (equity cushion) directly affect lenders' cost of capital. During stability, the spread on insured loans typically ranges from 1.20% to 1.60%, while for conventional loans, it varies between 1.50% and 2.20%.
The Broker's Strategic Role
The mortgage broker plays an essential role in compressing spreads for clients. By putting lenders in competition, channelling high volume of quality files, and maintaining strong relationships with multiple lenders, brokers obtain discounts that translate into narrower spreads for clients. Some high-volume Quebec brokers obtain 'net of commission' conditions (buy-down rates) that can represent a 0.10% to 0.20% advantage over posted rates. Transparency about rate structure and the broker's added value strengthens client trust and justifies the intermediary role in an increasingly digital market.